One of the weirder aspects of this financial crisis is that in most cases the amount of harm suffered by any given entity seems to have been directly proportional to the degree of financial sophistication that entity had. Structured products and statistical-arbitrage firms were the first to get hit; investment banking companies are next on the list. Meanwhile, dumb retail investors with S&P 500 index funds might not exactly be loving their returns, but have basically seen the value of their investment drop to 1300 now from 1400 a year ago.
Eventually, however, even dumb retail investors can be hit. And in a rather scary post this morning Herb Greenberg warns everybody with a brokerage account that they don’t own their securities. He quotes a letter from Mike Offit:
Contained in virtually every brokerage firm’s standard Account Agreement (generally a Margin Account) is a provision that allows your brokerage to register all your securities in street name, meaning their own. Every security you buy, even if you pay for it in full, might technically belong to your brokerage firm. It could be that all you really own is a claim on the firm for those stocks and bonds. When securities in your account are held in street name, says Eric Brunstad, Visiting Lecturer in Bankruptcy Law at Yale Law School, it’s really not your property. It’s like depositing money in a bank account. Your cash isn’t sitting in the vault in a box with your name on it. You are simply a creditor of the bank.
If Bear Stearns had gone bankrupt, then, everybody with a Bear Stearns brokerage account would have ceased to meaningfully own "their" securities. Instead, they would have had to join the line of creditors snaking out the front door of the courthouse.
If this kind of information becomes more widely known, could there be a wave of panicked selling? I don’t think so: Offit suggests not that you sell your securities, but rather that you move them to a custodial account at a Trust Bank. Still, a huge number of investors all trying to close and open brokerage accounts simultaneously is the last thing anybody needs right now.