Brokerage houses are awash in cash

By SmartMoney

Last year was actually pretty good for Frank Porcelli. When the markets started to roil, the Chicago-area accountant started trading and made some smart moves, buying oil and other commodities and shorting financials.

In just a few months, Porcelli earned about 8% on the $40,000 in his Roth individual retirement account and his brokerage account. But by August, he just couldn't take it anymore.

"The volatility was nuts -- up and down, up and down," he says. He logged on to his Wells Fargo account and clicked sell.

Where'd the money go? "Cash," Porcelli says. In other words, his "default" account, the brokerage equivalent of a shoebox. And five months later? Porcelli hadn't moved a dime.

Across the country, millions of Americans have been sitting on cash -- not at banks, not at credit unions, but in brokerage houses. Spooked by the crash on Wall Street last fall or nervous even earlier in the year, many dumped their mutual funds and bailed out of individual stocks. Then they gave their brokers one simple order -- put it in cash -- creating what analysts say could be a record amount of parked money.

Indeed, though no one knows the exact size of these accounts, rough estimates suggest they easily top $600 billion. At one brokerage alone, E-Trade (ETFC, news, msgs), 29% of all consumer assets were in cash by last fall, up from 17% in 2007.

'Swept' into shrinking yields

Today, much of this money continues to sit in accounts with names like "sweep," "core" and "cash management." But while these holding places may seem no different from a savings account to the average investor, experts say they are one of the worst places to park your cash. Their yields -- the interest they pay to account holders -- have been falling across the board as the Federal Reserve cuts rates.

And to make matters worse, most brokerages are simply paying less. Now some are offering rates as low as 0.01%, or $10 a year for every $100,000 invested. It's a terrible deal for the customers, according to Greg McBride, an analyst at Bankrate. The more money you have and the longer it sits, the worse it gets: "The difference in rates is significant, and every day counts," McBride says.

In their defense, brokerages say their cash accounts are only supposed to be temporary holding tanks, not long-term investments. Paying interest on the accounts has become an industry standard, so the brokerages do pay a nominal rate, but earning interest is not the purpose, says Jim Frawley, a spokesman at TD Ameritrade (AMTD, news, msgs), which pays 0.05% on its sweep account.

"It should be used for buying and selling; it's not for long-term cash," Frawley says. And brokerages acknowledge that investors can -- and should -- find higher rates elsewhere. Fidelity recently sent notes to investors who had money sitting in a core account for more than a year, reminding them that the account isn't a good choice for the long run.

But a year can really count, and analysts say brokers make more money if investors stay put. If an investor with $100,000 had spent 2008 in one of Fidelity's money market funds, she could have earned almost $3,000 in interest. In Fidelity's sweep account, $420.

And in recent years, the sweep accounts have gotten even worse for consumers. In 2007, the average sweep paid 2.7% in annual interest; today, it's paying less than 0.2%. Brokers "figure it's a captive audience," says Matt Bienfang, an analyst at the Tower Group. "They could pay more, but they don't."

Brokers profit from banking services

With investors dropping stocks and bonds like hot coals, cash is big business these days. But brokers have been hyping their cash-management abilities for almost a decade, ever since they started merging with banks. With campaigns such as "Total Merrill" and "Citi Never Sleeps," big firms like Merrill Lynch and Citigroup (C, news, msgs) have been promising to help with all of a customer's financial needs -- not just investments but credit cards, mortgages, and checking and savings accounts. In exchange for putting all their money in one place, customers could see all their financial information on one statement and, in theory, work with an adviser who understood their complete financial picture.

But banking services also became a huge cash cow for the brokerages. Customers who have all their assets in one place are less likely to move their money, and bank products can be more profitable than traditional investment accounts. And perhaps most important, the switch enabled brokerages to use bank deposit accounts instead of money market funds for their brokerage sweep accounts.

Until a few years ago, your extra cash usually went into a money market fund, where you could earn interest in the middle single digits. But money funds were not particularly profitable for the brokerage, which would earn only a small fee to run them. On a bank account, on the other hand, the broker could effectively pay whatever interest it wanted, reinvest the money at higher rates elsewhere and pocket the difference. Those spreads have been as wide as 3 percentage points, says Matt Snowling, an analyst at FBR Capital Markets. The profits have rolled in: Analysts estimate that Merrill made $2.4 billion by reinvesting customers' cash last year, up from $1.3 billion in 2004. (Merrill says it doesn't disclose that specific statistic.)

Continued: Missing out on interest

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