November 13, 2007

If You Want The Closest Thing To A Financial Disaster, Look To Etrade: How To Be Up 50% And Still Lose Everything

This is how I know we're entering a recession.

Etrade, ostensibly an electronic brokerage, also has a huge business as a bank-- and mortgage lender. To the tune of $42 billion. Which is at risk, a la Countrywide.

A Citigroup analyst downgraded Etrade, saying that there was a chance it could go bankrupt. It's not just the mortgages that are the problem, he explains, but nervous high net worth investors could pull their money "just in case," precipitating a further run on the bank and thus its eventual collapse. Anyone who has seen "It's a Wonderful Life" knows that the run on the bank is what implodes a bank, not something intrinsic to the bank.

And that's what has happened, is happening. No one wants to be the last one left. No one wants to be the hero and brave it out-- not to the tune of hundreds of thousands of dollars they could lose through no fault of their own.  You couldn't get through on the telephone.  People wanted out, or at least reassurance.

But let me be explicit about the cause. Etrade doesn't go out of business because the business failed; Etrade goes out of business because this guy said Etrade could go out of business. He even said it was only a 15% chance, but that's not what people heard. What they heard was, "fire!"

Let me also be clear about this: he's not wrong about Etrade. He causes himself to be right. Do you understand? Fundamentals don't matter here, only psychology.

You say: what do I care about Etrade?  I say: If Etrade collapses, your chance of a recession is 100%. Depression becomes a possibility.

Here's why.  If you default on your Countrywide mortgage, you lose your house, and Countrywide goes out of business. You lose money that you needed but that you never really had; you lose expected money. But if Etrade goes bankrupt, you could lose all your money even though you might be up 50% for the year.

First, the immediate impact of all losing that money means consumer spending falls gigantically. And that affects all the businesses one would have spent money at. Cancel Christmas.

Second, you will not be investing. Asset prices fall when demand dries up. Don't believe me? You think the selling yesterday was related to problems in Iraq? It was Etrade customers, trying to liquidate their portfolios and get out. And maybe some Ameritrade customers-- just in case, even though they had no problem. Etc.  That's why the stocks that fell were momentum names with large price tags-- people wanted cash.

Third, for the long term, you will be that much more wary about putting money in a "small" ($400billion?) brokerage. Retail investor stops investing. Want to know what that looks like? Hit up a chart from 2000.

But aren't these deposits government insured? No, and that's why this is so huge. About $15 billion of Etrade's deposits are over $100k-- the FDIC limit. So they guy who has $500k there will only get $100k back (after a long protracted struggle with the government.) That money vanishes, and it vanishes, unfortunately, from the pockets of the very people keeping the economy from evaporating. It's bad enough when the poor have cut back spending; if the rich cut back, the economy's finished.(1)

And this is how I know it won't happen.

An Etrade bankruptcy is so powerfully damaging to the our psychology of economics that it would devastate our already tenuous situation. It's also why I know we're in deflation, not inflation. When you liquidate your assets and pull them to cash-- for whatever reason-- you are pushing up the value of the dollar. You are not spending as much because you're not even sure how much you have anymore. I know prices are rising, but wages aren't. Prices could triple, if you're not spending it's irrelevant. Hoarding or not spending or not having ends up being the same force on the economy.

Deflation. On worry alone.  If Etrade actually goes bankrupt-....

So the government has no choice but to bail Etrade out. For the mental health of the economy, Etrade cannot die. Either the Fed will cut rates soon, or we'll hear a message from the Treasury. This isn't what I want or don't want, this is a bigger issue.

Jay-Z called the bottom in the dollar.  I call a bottom in Etrade, here, because I can't believe the government would let it happen.  So much, psychologically, is at stake.

Buying the stock here is a huge gamble, and I don't recommend it to anyone, but I figure if they don't save Etrade, it won't really matter how much I lose today anyway.

(long Etrade, and long the government-- for now.)


Who the hell keeps more tha... (Below threshold)

November 13, 2007 5:40 PM | Posted by Shalmanese: | Reply

Who the hell keeps more than $100,000 in a savings account?

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I hope you're right. I did ... (Below threshold)

November 13, 2007 7:11 PM | Posted by Demodenise: | Reply

I hope you're right. I did not factor a recession into my plan for repaying my grad school debt. Crap.

I'm not suddenly very nervous. Really.

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I'd love for some of these ... (Below threshold)

November 13, 2007 8:03 PM | Posted by Assrot: | Reply

I'd love for some of these psychiatrist's blogs to talk about the medicines they prescribe and how very, physically addictive they can be. For some reason I have had bad luck with shrinks to the point I will never see another one unless forced to do so. Everyone I have ever had has given me bad advice, bad medicine that they lied and said was not physically addictive and most have usually sent me to their idiot psychologist buddies once they bled my insurance for all it would pay. Can we get someone to tell the God's honest truth about psych meds and how truly addictive they really are and how hellish getting of of them is? I'm hoping that I just got a couple of bad ones and that the entire profession is not like that but I hear so many horror stories from other patients that I wonder.

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The problem with your predi... (Below threshold)

November 14, 2007 2:11 AM | Posted by Evan Goer: | Reply

The problem with your prediction about the bailout is that it takes some minimum level of competence to whisper in the right ears, grease the right palms, etc. Unfortunately ETrade, being staffed entirely by arrogant incompetent assholes, most likely failed to properly set up their bailout ahead of time. Oh well.

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But if Etrade goes... (Below threshold)

November 14, 2007 3:58 AM | Posted by Anonymous: | Reply

But if Etrade goes bankrupt, you could lose all your money even though you might be up 50% for the year.

You're aware that E*Trade brokerage accounts are SIPC insured, right?

That's not to say that it would be no sweat if your broker went bankrupt, but comparing a brokerage failure to a bank failure is just wrong. Banks keep a very small proportion of assets compared to their obligations to customers; e.g., a bank may actually have $1 of assets for every $10 of deposits it credits to clients. Brokers, on the other hand, keep a high proportion of actual securities compared to the amount that they credit to their clients. For every dollar that you give your broker to buy and hold GOOG in your behalf, the broker goes out, buys one dollar's worth of GOOG, and lends out a bit of the inventory to people who want to short the stock.

Just because a brokerage goes bankrupt doesn't mean that the inventory of securities will magically disappear. That inventory can be used to meet obligations to clients; and to the extent it falls short, the SIPC kicks in.

Of course, having your broker go bankrupt would definitely suck. You'd be unable to access your assets for some period of time, with significant uncertainty over whether you'll get back 100% of it. But you don't automatically "lose everything."

You are correct, you don't lose everything (well, everything under $500k.) But you do lose control of those assets for a while, say, three months. If you don't need the money, it may be ok; but it's hard to imagine not needing access to your money for three months: so spending goes down.

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You do realize brokerages a... (Below threshold)

November 14, 2007 3:27 PM | Posted by Dean J: | Reply

You do realize brokerages aren't FDIC insured, but have the (far larger) SIPC coverage, and usually pay for additional coverage on that...

The FDIC insures your (cash) deposits up to 100k; the SIPC insures your securities up to $500k. (See the bottom.)

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You are correct, y... (Below threshold)

November 15, 2007 12:09 AM | Posted by Anonymous: | Reply

You are correct, you don't lose everything (well, everything under $500k.)

Your answer can be read in such a way that I'm not sure you still get it.

The $500k figure doesn't mean that accounts with over $500k in assets only recover $500k. It means that to the extent that any securities that should be yours are actually missing from the brokerage, you can recover such securities up to $500k in value.

To put it as a toy example: you give your broker $700,000 to buy you 1000 shares of GOOG at $700. The broker buys them for you, and credits your account with 1,000 shares of GOOG. The broker lends out 100 of your shares to somebody who shorts it, goes bankrupt, and somehow never gets the 100 shares back. When your broker is being liquidated, then, there are only 900 of your 1,000 shares.

Those 900 shares are returned to you, and then the insurance kicks in for the missing 100 shares. Assuming the price of GOOG was still $700, 100 shares are $70,000. Your account was $700,000, which is more than that $500,000 limit of the insuracne, but that doesn't mean you only recover $500,000 worth, because the insurance applies to the 100 missing shares, not the 900 shares recovered from the broker.

The point, again, is that banks and brokerages are very different, because banks keep only a small fraction of deposits as a reserve. The brokerage credits you with 1,000 shares of GOOG, and lends out 100; the bank credits you with $1,000, and lends out $900.

Alone's response: Believe me when I tell you, I GET it-- for the past couple of days, I've dealt with nothing else... your example above is correct, but you are assuming a high recovery rate (for everyone else: I have an account of $1M, Etrade goes bankrupt, and they'er able to recover 95% of the assets, so everyone gets 95% of what they had, i.e. $950k-- the max $500k coverage is for my remaining missing $50k). While it's true that the coverage is almost always sufficient, you can imagine scenarios where it might not be. (I certainly am.) Also, the coverage isn't for dollars, but for shares. So if Etrade goes bankrupt today and I own GOOG, I have no ability to sell my GOOG until the SIPC actually gets it back (in the event it starts declining.)

But I'm not really worried about losing my money (or anyone else losing it), I am more concerned with the GIGANTIC psychological impact this will have on the "average" investor. Which is why I am betting that the govt will not let it happen. Today I read that the Fed probably won't cut rates in Dec. No way-- not only do they cut, but they may even cut before then if the fan starts getting hit...

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".......The point, again... (Below threshold)

November 15, 2007 9:47 PM | Posted by Wally: | Reply

".......The point, again, is that banks and brokerages are very different, because banks keep only a small fraction of deposits as a reserve. The brokerage credits you with 1,000 shares of GOOG, and lends out 100; the bank credits you with $1,000, and lends out $900."

My questions is, Who is making sure (monitoring) that the broker only lends out 100? Who’s monitoring? Desperate times call for desperate measures.

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Still long on Yen, Gold and... (Below threshold)

November 16, 2007 3:28 AM | Posted by Whatever: | Reply

Still long on Yen, Gold and Oil. Short on the dollar.

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If you've been following th... (Below threshold)

November 19, 2007 12:49 AM | Posted by Tai: | Reply

If you've been following this story, on a lighter note you might want to check out this video with the famous chimp from those Super Bowl commercials:

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