Are You Prepared For Custody Risk?

A lot of pundits have recently been commenting that short-term T-bills are a safe haven for investors. The idea behind this claim is that the US has a printing press and can always insure the return OF capital though with interest rates at 0%, T-bills currently offer no return ON your capital.

This idea basically makes sense, except for the issue of custody risk.

What’s custody risk?

The risk of loss of securities held in custody occasioned by the insolvency, negligence or fraudulent action of the custodian or subcustodian. Even if an appropriate legal framework is in place, which eliminates the risk of loss of value of the securities held by the custodian in the event of its failure, the ability of participants to transfer the securities might be temporarily impaired.

In plain terms, custody risk is the risk that if the financial entity that holds your securities for you (say a brokerage firm or money market fund) goes bust, you cannot get the securities back. As the above definition also indicates, even if there is a legal framework to insure you can GET the securities, you may have to wait a while.

What is all boils down to is the following: when you buy a T-bill, what do you ACTUALLY own?

The answer is an IOU from the US Government. But what is that? It’s a contract between you and the US Treasury that you will be paid back at some point. So this is not a tangible item like a brick, it’s just a promise (one that the US can default on if it chooses).

Now most people house this “promise” or IOU at a bank, broker, or financial firm (the “custodian”).  But as my last few essays have revealed, the financial system today continues to be at grave risk of another collapse. Indeed, many renowned  investors, particularly John Hussman, have noted that the entire US banking system is effectively insolvent.

So, what happens to your T-bill if we have another serious Crisis and the system starts to implode again taking down your custodian with it?

At best, you’ll have to wait a while to get the T-bill transferred to a new account from the rubble of your old custodian.

At worst, you’re up “you know what creek” without a paddle.

Mind you, I’m only discussing custody risk, I’m not even beginning to address the US’s unserviceable debt load, the continued “strangeness” in US Treasury auctions, and the fact that history, with few exceptions, indicates that whenever a country hits a point of debt saturation (when it can never repay its debts) it tries to inflate the debts away, fails, and usually then defaults.

Many folks will laugh at me for even suggesting that the US can default on its debts, but at this point, with some $60+ trillion in liabilities outstanding (when you include Social Security and Medicare) what is the other option… turn the US Dollar to confetti, sending us into a Zimbabwean nightmare?

Is that any better? Think that T-bill will have any value then either?

Bottomline, if you put your cash in a T-bill, you’re first handing your money off to the US Government (hardly a fiscally prudent manager), then housing the IOU it gives you in return with a custodian (usually a financial firm) which may, for all you know, be sitting atop loads of hidden debt or liabilities that it’s hiding via various accounting gimmicks, charades, etc.

Thus, you are getting two significantly “at risk” entities involved with your money. And for what? 0.01%?

Is the risk really worth it?

If you’re an ordinary investor (not someone with MILLIONs lying around) and you want to park your cash somewhere, why not just put it in actual physical cash in a safe in your house? That way YOU’RE the custodian of your money. And you don’t have to worry about your bank going under or the “custodian” disappearing leaving you with nothing.

Which would you prefer? Your money or an IOU?

In tomorrow’s essay I’ll address the actual potential of a real bout of hyperinflation (I realize I left a loose end in mentioning the potential of a Zimbabwean future in today’s essay). Until then…

Good Investing!

Graham Summers

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