GUILD GLOBAL MARKET COMMENTARY
by Monty Guild & Tony Danaher
Guild Investment Management, Inc.
August 4, 2009
You may remember that about a year and a half ago we began a campaign to inform our clients and readers of certain risks to their financial assets that exceed SIPC (Securities Investor Protection Corp.) insurance limits of $500,000 (up to $100,000 in cash is insured and up to $400,000 in securities is insured).
Many brokerage firms previously purchased insurance from major insurance companies to provide insurance for client accounts that exceed the SIPC limits. However, earlier this decade, the major insurers stopped offering excess SIPC insurance to brokerage firms. Apparently, the major insurers were prescient on the risks of brokerage firm solvency.
As a result of the loss of excess insurance for larger accounts, in 2003 many brokers banded together to form a private insurance company called CAPCO (Customer Asset Protection Company) to insure their clients accounts above $500,000 . In theory, the industry would self insure against the failure of one of its members.
Lehman was a member of the CAPCO consortium. When Lehman went bankrupt in September 2008, many large investors lost money and assets that were deposited at Lehman. CAPCO was supposed to insure the losses in excess of $500,000. Not surprisingly, it appears that CAPCO was under funded and may not have the money to pay the creditors.
This following article explains why we have suggested that our clients and readers consider having their assets that exceed the SIPC and FDIC insurance limits held in custody accounts, preferably in the private banking division of a major bank. We have looked for custodians whose legal documentation includes provisions describing the segregation of assets and audits to ensure that client assets are segregated from the assets of the institution itself and from the assets of every other client of the institution.
Please read the article below from the New York Times for a great deal more information.
Billions in Lehman Claims Could Bury an Elusive Insurer
By ZACHERY KOUWE, July 30, 2009
Next to a Chinese restaurant in Burlington, Vt., lurks a quiet guardian of Wall Street — an obscure insurance company that is supposed to protect big-money investors in the event of a catastrophic failure of a major brokerage firm.
A failure, for instance, like the one that brought down Lehman Brothers nearly 11 months ago. Now, after years in the shadows, the insurer, the Customer Asset Protection Company, could finally be put to the test, and questions are starting to swirl.
The worry is that the company, which has never paid out a claim, might be unable to cope with the Lehman bankruptcy.
If it were overwhelmed by claims, the banks and brokerage companies that own Capco, as it is known, could end up owing billions of dollars.
Capco representatives dismiss such concerns, but state insurance regulators are keeping an eye on the company. Officials at the New York State Insurance Department are concerned about the company’s ability to withstand the Lehman bankruptcy, the largest in history.
By some industry estimates reviewed by the insurance department, Capco could face nearly $11 billion in claims but has only about $150 million with which to meet them. The state is examining whether the company sold policies without the means to cover them, according to a person with direct knowledge of the inquiry who had signed confidentiality agreements.
The issue has even reached Washington, where a member of the Senate Finance Committee, Robert Menendez, has sounded an alarm. Mr. Menendez, Democrat of New Jersey, wrote the Treasury secretary, Timothy F. Geithner, in June to express his concern.
“It has become clear that this entity is thinly capitalized,” Mr. Menendez wrote in the letter. Capco, he said, potentially posed “systemic risk.” Capco was created in 2003 by Lehman and 13 other banks and brokerage companies as a kind of marketing tool. The pitch was that while Capco would not insure customers against investment losses, it would compensate them if the firms failed. Capco promises to provide virtually unlimited coverage above the $500,000 offered by the Securities Investors Protection Corporation and its equivalent in Britain.
Capco is virtually unknown even in financial circles, but it is being thrust into the spotlight by the events at Lehman. Creditors and former customers are battling over who will get what and when from the fallen bank, including more than $32 billion of assets that have been tied up in Lehman’s London prime brokerage unit. Untangling the mess could take years. Some former Lehman clients, which include big hedge funds, are looking to Capco for answers — and money.
Dewey & LeBoeuf, the law firm that represents Capco, said in a statement that Capco had no current policies outstanding and was “preserving all assets to address claims that might arise out of the insolvency of Lehman Brothers Inc. and Lehman Brothers International (Europe).”
The law firm called worries about Capco’s potential exposure to Lehman “speculation.”
Capco, which is private, is something of a financial mystery. Its members include Wall Street giants like Morgan Stanley and Goldman Sachs, banks like JPMorgan Chase and Wells Fargo, smaller brokerage firms like Robert W. Baird & Company and Edward Jones, and Fidelity, the mutual fund giant. Capco was initially registered in New York but later moved to Vermont, where state law enables it to operate without disclosing much about its finances.
Capco’s owners referred questions about the company’s liability to Dewey & LeBoeuf. Since it stopped writing policies on Feb. 16, most of Capco’s owners have purchased account protection for their clients through private insurance companies like Lloyd’s of London. Pershing, a unit of Bank of New York Mellon, told clients in a December notice that their Capco insurance would expire and that the firm had a new policy with Lloyd’s to “provide our customers and their investors with extra comfort that their assets are safe.”
It’s unclear who actually serves as the current president of Capco, and the company’s main phone number connects to a recording that tells callers they’ve reached a “nonworking number at Morgan Stanley.” A unit of Marsh & McLennan, the giant insurance services company, is listed as Capco’s administrator, but no Contact Information is listed on Capco’s Web site. The unit is based in the same Burlington building as Capco.
Brokerage companies used to buy account protection insurance from large insurance companies like Travelers and the American International Group. But in 2003, those insurance companies stopped offering such policies, saying it was impossible to calculate their liability. Enter Capco.
The Capco members played up their coverage when pitching their brokerage services to clients, especially large hedge fund customers who could lose billions of dollars if a firm went under. Although Capco’s finances were never disclosed publicly, the company was initially a given high rating by Standard & Poor’s.
That rating, however, was cut to junk status last December, and the ratings were withdrawn altogether in February. In its report, S.& P. said it was concerned about potential claims from customers of Lehman’s London unit, which “could create a liability for Capco that exceeds the insurer’s resources.” Charles Schwab, UBS and Merrill Lynch never opted for Capco, arguing that the arrangement seemed risky. Schwab requested the company’s financial statements from the insurance department through a Freedom of Information Act request in 2004, but was told the books were confidential.
The New York State Insurance Department later told Capco’s members that the company would eventually have to release the information. Before that happened, however, Capco relocated to Vermont, a haven for so-called captive insurance companies, whose owners are the ones buying the policies.
“Right away, the whole Capco thing just did not pass the smell test,” said Robert Meave, an outside consultant for Schwab at the time, who evaluated the insurance company. “Schwab was not about to go to their clients and tell them we’re providing account protection and, oh by the way, they were owners of the insurance company.”
Firms who sought coverage elsewhere, mainly through Lloyd’s of London, could buy only up to $150 million of insurance per account and a maximum of $600 million for the entire firm. As a result, some customers moved their money to firms that offered Capco coverage.
“Let’s face it, none of us could have foreseen an event like Lehman, but we didn’t feel the capitalization of Capco as it seemed to be forming was going to be adequate in the extremely unlikely event that something happened,” Mr. Meave said.
Owners of the assets tied up in Lehman’s London unit, including pension funds and university endowments, believe they may have claims against Capco if all of their money is not returned by Lehman’s liquidator.
If Capco can’t pay out the claims and files for bankruptcy, several customers said they would bring lawsuits against the other brokerage houses.
“The bottom line is, this insurance should have never been sold to clients, and it just shows how Wall Street again miscalculated the risks involved with one of their own going under,” said an adviser working on the Lehman bankruptcy who was not authorized to speak for the company.
© 2009 Monty Guild
& Tony Danaher