brokerage failure & risk premium for t-bill & cd

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fatherted
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brokerage failure & risk premium for t-bill & cd

Post by fatherted » Sun Nov 18, 2018 4:01 pm

I am interested in evaluating various options for short term cash, held in an after tax account.
Given a term of 1-yr, and the goal of capital preservation, as opposed to wealth preservation, I see these available options:

1. 52-week t-bill, purchased from treasury direct.
yield: last non-competitive result on 11/8/18 2.737%
tax: yield is free of state tax, adding a ~9% boost in CA when compared to a CD product of similar term
risk factors: likelihood of non or partial return of capital from UST - nil.

2. 52-week t-bill, purchased through brokerage (Schwab, Vanguard, Fidelity, etc)
yield: assuming no purchase or maturity commission, the yield should be the same as in (1).
tax: does the state tax free treatment pass through in this case, as in (1)?
risk factors: potential loss of principal?
Comment: who holds title to the t-bill - the brokerage in "street name", or the named account holder? That is to say, if the brokerage fails, is the t-bill separate from the brokerage's assets and so be free from seizure by the brokerage's creditors?

3. 1-yr CD purchased directly from a bank.
yield: as of 11/18/18 bankrate.com shows 2.7% for Citizens Access bank.
tax: the after tax yield will be dragged down by Fed & state tax and so will be less than (1)
risk factors: potential loss of principal?
Comment: similar concern as for (2). If the bank fails, I understand that FDIC will step in and make the account holder whole, although with loss of interest, upto the $250k limit. However, how long will that take for resolution? Also, if a big retail bank fails, will FDIC have sufficient reserve to pay out at 100c on the $?

I understand that (1) is least risky in terms of return of capital, whilst also affording the highest after tax yield. Whereas (2) and (3) appear to encompass more risk, why is there no corresponding risk premium. In other words, I would expect (2), and definitely (3) to offer a higher yield than (1) due to the increased risk to principal and the disadvantageous tax treatment.

With respect to the FDIC's ability to ameliorate bank failure risk, and make account holders whole, I observe that:
- the FDIC is only obliged to keep on hand a Designated Reserve Ratio of 2% of total insured deposits.
- FDIC annual report for 2017 shows a reserve of $92B but which is only 1.28% of their total insurance liability
- the total assets held by the banks that FDIC insures totals $16B, therefore a multiple, cascading bank failure would be totally beyond FDIC capacity
- it is solely funded by premiums paid by the banks, with no congressional appropriations mandated.
- if FDIC is overwhelmed, it appears that congressional action would be required but would be, by no means, certain.
- whilst I understand that bank leverage is lower than in 2008, I perceive that these banks are now larger through acquisition. Thus, if one main street bank fails, then I doubt FDIC's capacity.

Given the above points, it appears that (1) is the best option for the stated goal.
Am I missing something blindingly obvious here?
Have I overstated the risks of (2), (3), or of the FDIC?
Are my concerns about the assets held by a brokerage on my behalf overblown?


Disclosures:
I buy 28-day t-bills on a weekly ladder for near term capital preservation.
I purchase using treasury direct, and hold to term before re-investing.
I was an account holder at a failed bank about 12 years ago. Fortunately I recovered principal but only after 6months of wrangling.

alex_686
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Re: brokerage failure & risk premium for t-bill & cd

Post by alex_686 » Sun Nov 18, 2018 5:14 pm

Welcome to the forum.
fatherted wrote:
Sun Nov 18, 2018 4:01 pm
Comment: who holds title to the t-bill - the brokerage in "street name", or the named account holder? That is to say, if the brokerage fails, is the t-bill separate from the brokerage's assets and so be free from seizure by the brokerage's creditors?
My day job used to be the above question. Assets are held in street name in a segregated account. If the bank goes under the assets in the segregated accounts are - well - segregated. So totally safe. This is heavily ringed fenced by regulations, internal and external audit, and SPIC insurance. Even if the assets are comingled with the banks assets - for example you margin your Treasury - you would still probably get your assets back. I have had ring side seats to a couple of bankrupt brokers and I can only think of one instance in the past 40 years where a client has had to take a haircut.

I think your 3rd example is also pretty far fetched.
FDIC only has to make up the difference between assets and liabilities - after all equity has been eaten away. Most banks get liquidated before all of the equity has been eaten away.
There was no obligation for the government to bail out Fredie Mac or Fannie Mae in 2008, yet they did. There is strong implicit backing here.
And when things looked troublesome in 2008 the Fed flood the market with liquidity and opened up its discount window to even sub-par stuff.

fatherted
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Re: brokerage failure & risk premium for t-bill & cd

Post by fatherted » Sun Nov 18, 2018 5:44 pm

alex_686 wrote:
Sun Nov 18, 2018 5:14 pm
Welcome to the forum.
Thanks very much. I appreciate your time in making a response.
alex_686 wrote:
Sun Nov 18, 2018 5:14 pm
fatherted wrote: ↑Sun Nov 18, 2018 1:01 pm
Comment: who holds title to the t-bill - the brokerage in "street name", or the named account holder? That is to say, if the brokerage fails, is the t-bill separate from the brokerage's assets and so be free from seizure by the brokerage's creditors?
My day job used to be the above question. Assets are held in street name in a segregated account. If the bank goes under the assets in the segregated accounts are - well - segregated. So totally safe. This is heavily ringed fenced by regulations, internal and external audit, and SPIC insurance. Even if the assets are comingled with the banks assets - for example you margin your Treasury - you would still probably get your assets back. I have had ring side seats to a couple of bankrupt brokers and I can only think of one instance in the past 40 years where a client has had to take a haircut.
OK, this is encouraging. Thus, even if account holder assets are co-mingled, the account holder still retains all rights of ownership to those assets. This does beg the question of how long before those assets might be freed up and transferred to a solvent institution? Would you say we're talking weeks, months, or longer? Presumably there is a process that must be followed to establish ownership, prior to disbursement or disposal?
alex_686 wrote:
Sun Nov 18, 2018 5:14 pm
I think your 3rd example is also pretty far fetched.
FDIC only has to make up the difference between assets and liabilities - after all equity has been eaten away. Most banks get liquidated before all of the equity has been eaten away.

I accept your comment. In this query, I am exploring the limits so as to determine the overall landscape.
alex_686 wrote:
Sun Nov 18, 2018 5:14 pm
There was no obligation for the government to bail out Fredie Mac or Fannie Mae in 2008, yet they did. There is strong implicit backing here.
And when things looked troublesome in 2008 the Fed flood the market with liquidity and opened up its discount window to even sub-par stuff.
I agree, there was no mandate to bail out those GSE. The publicly stated reasons for bail out have been well advertised. However, it does not automatically follow that the the next GSE will be rescued as the prevailing view on main street suggests. Given another outbreak of trouble, does the FED have the same capacity to flood the market with liquidity? Obviously the answer would be "it depends", however, I think it's an appropriate question to consider.

Ultimately, my thinking goes along the lines of:
- the USG is the ultimate guarantor, either explicitly through FDIC, or implicitly through bailout
- t-bill provide similar or tax advantaged yield in my cited examples
- why bother with an intermediary, when you can go to the source?

alex_686
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Re: brokerage failure & risk premium for t-bill & cd

Post by alex_686 » Sun Nov 18, 2018 6:07 pm

fatherted wrote:
Sun Nov 18, 2018 5:44 pm
OK, this is encouraging. Thus, even if account holder assets are co-mingled, the account holder still retains all rights of ownership to those assets. This does beg the question of how long before those assets might be freed up and transferred to a solvent institution? Would you say we're talking weeks, months, or longer? Presumably there is a process that must be followed to establish ownership, prior to disbursement or disposal?
It depends on how badly the broker went bankrupt. Worse case the retail arm would be sold to a solvent broker, all of the accounts would be transferred across automatically, and you would deal with a new broker. Days to weeks.

A note - "retains all rights of ownership to those assets" implies a specific legal structure which is technically not true. I worked for a company that had millions in assets comingled with Lehman Brothers when they went bankrupt. This far exceeds SPIC insurance. We got every dollar back in a short month. We did not get the actual assets back. We did not having voting rights during that period.
fatherted wrote:
Sun Nov 18, 2018 5:44 pm
- why bother with an intermediary, when you can go to the source?
Because CDs tend to offer higher rates than Treasuries, have lower transaction costs, are easier to liquidate, and are more convenient.

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mhadden1
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Re: brokerage failure & risk premium for t-bill & cd

Post by mhadden1 » Sun Nov 18, 2018 6:37 pm

fatherted wrote:
Sun Nov 18, 2018 4:01 pm

3. 1-yr CD purchased directly from a bank.
yield: as of 11/18/18 bankrate.com shows 2.7% for Citizens Access bank.
tax: the after tax yield will be dragged down by Fed & state tax and so will be less than (1)
risk factors: potential loss of principal?
Comment: similar concern as for (2). If the bank fails, I understand that FDIC will step in and make the account holder whole, although with loss of interest, upto the $250k limit. However, how long will that take for resolution? Also, if a big retail bank fails, will FDIC have sufficient reserve to pay out at 100c on the $?
Sometimes banks and credit unions run specials to get business, so a rate better than 2.7% is definitely possible if you look around. Sometimes it can be a little bit of trouble to qualify for a particular credit union membership.

I personally do not worry at all about accounts with federal deposit insurance. I am never able to exceed the balance limits and such. :(
Oh I can't, can I? That's what they said to Thomas Edison, mighty inventor, Thomas Lindberg, mighty flyer,and Thomas Shefsky, mighty like a rose.

Nate79
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Re: brokerage failure & risk premium for t-bill & cd

Post by Nate79 » Sun Nov 18, 2018 7:45 pm

I have FAR more worry to some type an issue at Treasury Direct than at a broker. Search past threads on the lack of transparency in any type of support you will get if your money goes missing from Treasury Direct.

AlohaJoe
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Re: brokerage failure & risk premium for t-bill & cd

Post by AlohaJoe » Sun Nov 18, 2018 8:15 pm

fatherted wrote:
Sun Nov 18, 2018 4:01 pm
Have I overstated the risks of (2), (3), or of the FDIC?
If you buy T-bills, I don't think the FDIC has anything to do with it?

The FDIC doesn't cover securities. You'd need to look at SIPC, right?

But the response to a scenario like this isn't usually handled by the FDIC or SIPC per se but by the SEC directly (with assistance from lots of places, including SIPC, FINRA, the Federal Reserve, etc). Take a look at what happened with Lehman: https://www.sec.gov/news/press/2008/2008-215.htm

As that SEC press release says: if the broker is sold (as happened with Lehman) then clients get access back in 2-3 days. If the broker has to actually go through liquidation then it takes weeks. That is why the SEC & other parties work really, really hard to find a buyer because they don't want people to go through that.

alex_686
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Re: brokerage failure & risk premium for t-bill & cd

Post by alex_686 » Sun Nov 18, 2018 9:17 pm

AlohaJoe wrote:
Sun Nov 18, 2018 8:15 pm
fatherted wrote:
Sun Nov 18, 2018 4:01 pm
Have I overstated the risks of (2), (3), or of the FDIC?
If you buy T-bills, I don't think the FDIC has anything to do with it?

The FDIC doesn't cover securities. You'd need to look at SIPC, right?
#1 & 2 are Treasuries, #3 is for CDs. OP is looking for a ultra-safe short term vehicle.

fatherted
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Re: brokerage failure & risk premium for t-bill & cd

Post by fatherted » Sun Nov 18, 2018 11:37 pm

alex_686 wrote:
Sun Nov 18, 2018 9:17 pm
A note - "retains all rights of ownership to those assets" implies a specific legal structure which is technically not true. I worked for a company that had millions in assets comingled with Lehman Brothers when they went bankrupt. This far exceeds SPIC insurance. We got every dollar back in a short month. We did not get the actual assets back. We did not having voting rights during that period.
Thanks for the clarification on rights, that makes sense - the voting rights, and the reimbursement of the cash equivalent.
alex_686 wrote:
Sun Nov 18, 2018 6:07 pm
Because CDs tend to offer higher rates than Treasuries, have lower transaction costs, are easier to liquidate, and are more convenient.
You surprise me but then perhaps I've not searched as diligently as you. Certainly, for the at least the last two years bank CD rates have been pitiful and about on a par with t-bills.
mhadden1 wrote:
Sun Nov 18, 2018 6:37 pm
Sometimes banks and credit unions run specials to get business, so a rate better than 2.7% is definitely possible if you look around. Sometimes it can be a little bit of trouble to qualify for a particular credit union membership.
I agree, I have seen this specials in the past and participated once. However, it only works with new money brought to the bank, and can't be rolled over. It's a marketing gimmick, not worth the trouble of opening accounts.

fatherted
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Re: brokerage failure & risk premium for t-bill & cd

Post by fatherted » Sun Nov 18, 2018 11:47 pm

Nate79 wrote:
Sun Nov 18, 2018 7:45 pm
I have FAR more worry to some type an issue at Treasury Direct than at a broker. Search past threads on the lack of transparency in any type of support you will get if your money goes missing from Treasury Direct.
Thanks for your comment, this is news to me. Just to clarify, are you saying that TD loses track of account holders' assets?

Nuestroro
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Re: brokerage failure & risk premium for t-bill & cd

Post by Nuestroro » Mon Nov 19, 2018 12:50 am

FDIC is really good at resolving banks over a weekend to minimize inconvenience to depositors. Since FDIC’s inception in 1933, nobody has lost a penny on insured deposits. In the event of catastrophe, FDIC has a line of credit at the Treasury. Ultimately, insured deposits are backed by the full faith and credit of the federal government: the government would have to default before you lost a penny.

Given the federal guarantee, bank deposits have less credit risk than T-bills: a bill is an obligation of the Treasury, while a deposit is an obligation of a bank and (ultimately) the Treasury. Now, we can debate how likely a bank will be able to pay depositors if the Treasury defaults, but surely the chance is greater than zero.

SIPC protection is similar but not as strong. SIPC has a Treasury line of credit, but only $2.5 bn. It is not backed by full faith and credit. And it resolves its claims more slowly than FDIC. Typical cases are a week; Lehman took several weeks.

fatherted
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Re: brokerage failure & risk premium for t-bill & cd

Post by fatherted » Mon Nov 19, 2018 1:12 am

Nuestroro wrote:
Mon Nov 19, 2018 12:50 am
Given the federal guarantee, bank deposits have less credit risk than T-bills: a bill is an obligation of the Treasury, while a deposit is an obligation of a bank and (ultimately) the Treasury. Now, we can debate how likely a bank will be able to pay depositors if the Treasury defaults, but surely the chance is greater than zero.
Thanks for you comment, however, I don't understand your logic. How can a bank have a lower credit risk than the UST if the UST eventually back stops the bank?

Nate79
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Re: brokerage failure & risk premium for t-bill & cd

Post by Nate79 » Mon Nov 19, 2018 6:53 am

fatherted wrote:
Sun Nov 18, 2018 11:47 pm
Nate79 wrote:
Sun Nov 18, 2018 7:45 pm
I have FAR more worry to some type an issue at Treasury Direct than at a broker. Search past threads on the lack of transparency in any type of support you will get if your money goes missing from Treasury Direct.
Thanks for your comment, this is news to me. Just to clarify, are you saying that TD loses track of account holders' assets?
I am not saying it has happened. I am saying that it is not clear that TD has any obligation in case your assets held at TD go missing, say due to account hacking. There were a few threads on this in the past.

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jeffyscott
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Re: brokerage failure & risk premium for t-bill & cd

Post by jeffyscott » Mon Nov 19, 2018 10:30 am

fatherted wrote:
Sun Nov 18, 2018 4:01 pm
2. 52-week t-bill, purchased through brokerage (Schwab, Vanguard, Fidelity, etc)
yield: assuming no purchase or maturity commission, the yield should be the same as in (1).
tax: does the state tax free treatment pass through in this case, as in (1)?
Yes, the t-bill interest is not subject to income tax, whether held at a brokerage or TD.

As you have seen there is no reason to go with a CD with a 1 year term, unless you find a special deal. Brokered 1 year new issue CDs are at 2.8%. Even with a tax rate of about 5%, the Treasury is better based on the latest yield curve rate of 2.68%.

To me the only significant differences between a brokerage and TD is the brokerage lets you buy secondaries and provides greater liquidity. The only other things that I can think of are that TD allows any amount in multiples of $100 vs. multiples of $1000 at a brokerage and TD has an automatic reinvest feature.

If you want to sell early, you can't at TD. There is a fee and a complicated process to transfer to a brokerage.

With brokerage, if you are willing to buy on secondary market, you can do it whenever you want, so you don't have to wait for the next auction.
press on, regardless - John C. Bogle

Turbo29
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Re: brokerage failure & risk premium for t-bill & cd

Post by Turbo29 » Mon Nov 19, 2018 11:41 am

Nuestroro wrote:
Mon Nov 19, 2018 12:50 am
FDIC is really good at resolving banks over a weekend to minimize inconvenience to depositors. Since FDIC’s inception in 1933, nobody has lost a penny on insured deposits. In the event of catastrophe, FDIC has a line of credit at the Treasury. Ultimately, insured deposits are backed by the full faith and credit of the federal government: the government would have to default before you lost a penny.

Given the federal guarantee, bank deposits have less credit risk than T-bills: a bill is an obligation of the Treasury, while a deposit is an obligation of a bank and (ultimately) the Treasury. Now, we can debate how likely a bank will be able to pay depositors if the Treasury defaults, but surely the chance is greater than zero.

SIPC protection is similar but not as strong. SIPC has a Treasury line of credit, but only $2.5 bn. It is not backed by full faith and credit. And it resolves its claims more slowly than FDIC. Typical cases are a week; Lehman took several weeks.
Largest bank failure to date was Washington Mutual in 2008. I had several accounts with them, saw it on the news Friday, Sept 26 (The official failure date is Sept 25), logged in and saw a notice that Chase had taken over. Website still functioned, I could still ACH funds in and out, etc. Not a moment's disruption.

Ten years later still using my WaMu checks (I write very few) and they work fine.

robertmcd
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Re: brokerage failure & risk premium for t-bill & cd

Post by robertmcd » Mon Nov 19, 2018 11:56 am

With the new bail in provisions post GFC, treasuries are now safer than FDIC funds. In event of nationwide bank failures, the FDIC does not have to insure your deposits if your money is need to prevent systemic collapse due to derivative exposure of too big to fail banks. I doubt that they wouldn't, but it is still a risk.

alex_686
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Re: brokerage failure & risk premium for t-bill & cd

Post by alex_686 » Mon Nov 19, 2018 12:03 pm

Nate79 wrote:
Mon Nov 19, 2018 6:53 am
I am not saying it has happened. I am saying that it is not clear that TD has any obligation in case your assets held at TD go missing, say due to account hacking. There were a few threads on this in the past.
I will extend a bit. TD is a low cost provider and a bureaucracy. You are not going to get high quality service. Nobody is going to hold your hands if you need help. Not that I want my tax dollars going to white glove service. It is what it is.

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