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Charles Schwab (SCHW)
Talk to Chuck But Don't Expect Him to Have all the Answers
Chuck Schwab is not one to go down without putting up a fight. Earlier this decade, when his namesake brokerage firm was struggling in the aftermath of the tech bubble and the subsequent decline in online trading, he came back, replaced the CEO and started running the place again full-time. Assets under management have grown exponentially since his return in 2004 and the firm is once again in good health. However, there is this pesky issue of auction-rate securities (ARS). Andrew Cuomo, NY's Attorney General (aka Spitzer part deux) sued the brokerage firm for failing to disclose risks associated with ARS to clients. The biggest names on the street from Goldman, Morgan down to brokers like TD Ameritrade, have faced these accusations and have settled with Cuomo. But Schwab surprisingly is putting up a very public fight, why?
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Auction rate securities are long-term bonds with a twist -- the interest rates on them reset frequently (e.g. every 7 days) based on the demand for these securities, as determined by a Dutch auction. Even though they are long-term bonds, the fact they change hands so frequently makes them equivalent to short-term investments which allows the issuers to pay a lower interest rate. On the other hand, investors get a higher rate when compared to other short-term investments such as CDs, treasuries etc. The key is that these auction rate securities were marketed as cash equivalents because everybody figured there are auctions held for them so frequently that liquidity is not an issue. And for 20 years it wasn't a problem until early last year when the big banks weighed down by the mortgage assets on their books decided to stop making a market for these securities and withdrew their liquidity support. The market for ARS froze and retail investors were left holding the bag with these investments. Subsequently, Andrew Cuomo threatened to sue the banks (i.e. the underwriters) and the brokers (i.e. the distribution channels). One by one, each of these entities settled with Cuomo (who by the way is armed with the Martin Act of New York, one of the most powerful and wide-ranging statutes in the nation) and agreed to buy back the illiquid investments from the retail investors at par.
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Charles Schwab refused to join the settlement party; therefore, Cuomo sued the firm last Monday even producing samples of conversations between brokers and clients in which the former assured the latter that ARS are as liquid and safe as cash. Cuomo claims that Schwab should have educated its brokers better so they wouldn't have said stuff like that. Chuck Schwab (the person) fired back with an op-ed piece in the Journal this week claiming a) most clients that Schwab serves use the firm as a broker not as investment advisor, therefore, Schwab is not obliged to provide them with advice, b) even if Schwab was acting in an advisory role, it would have been very hard for Schwab to foresee the problems in the ARS market because nobody else (including Cuomo and the rest of the regulatory community) saw them coming either and c) if you really want to blame somebody for this, it should be the banks and the major brokerage houses that created these securities, underwrote them and promised to always provide liquidity, you shouldn't be blaming a downstream minor player like Schwab that just made these securities available to clients if/when they demanded them.
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One can debate the merits of both sides of these arguments all day, and in the end, this thing will probably not go to court as both parties will settle out of it, once they can agree on an amount that Schwab should pay. But this episode is important for two reasons, a) Schwab is taking a gamble in going public. Most casual observers will not take the time to understand the issues at hand and will just assume that Schwab was trying to dupe the helpless retail investor (just like all the financial firms do). Even though that perception is far from the truth, it's the easy conclusion to jump to and for a firm like Schwab, which is heavily reliant on client-side advertising and its ubiquitous 'talk to Chuck' campaigns, this is an image problem. And b) these kinds of issues are a long-term threat to Schwab's business model. Schwab was founded on the low-cost model of service. To be low cost, you have to be light on the services you provide. One of those services is investment advice. But if lawsuits such as these are going to set the precedent that brokers like Schwab have to meet a much higher threshold in how much they educate simple brokerage clients, then that is going to add to Schwab's cost structure. Chuck Schwab made this argument is in his op-ed and it shows that the real reason Schwab took the risk of standing up to Cuomo on auction rate securities is because he sees the ship sailing towards the land of increased investor protectionism and that is not a cheap place to do business.
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Other Stuff Related to Schwab
Schwab stands its ground in ARS dust-up -- but at what cost? -- Remember, you are messing with a guy who wants to be governor
Did Chuck Do His Job? -- The NY Times editorial position on this should not surprise you
Is Schwab to blame for investments gone bad? -- Framing the issue in a broader context
What else is making news?
Sirius is again looking at the iPhone to drum up business
Boeing: One of these days (or years), we will fly this Dreamliner thing
When it rains it pours -- People just can't seem to leave Goldman alone -- now Massachusetts wants its piece of blood
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