When interest rates started to rise a couple of years ago, it was a bonanza for wealth management firms, which could make extra interest off client money parked in short-term overnight bank accounts. But cash sweep accounts have recently won attention for all the wrong reasons.
Typically these accounts aren’t for long-term investing but instead hold short-term proceeds from things like dividends or interest or monies for commission payments. The money the firms make off these accounts goes directly to their bottom lines, and their net interest income has skyrocketed as a result.
But lawyers and regulators argue that even overnight parked money ought to be working for the clients, not the financial companies. Several client lawsuits, meanwhile, have brought that argument to federal courts.
Now one of the ratings agencies says that the pressure to increase rates on these accounts could hurt the credit of wirehouses and broker-dealers, especially if these companies are too burdened with debt they have to service.
Last week, Moody’s issued a report called “Rising Attention On Cash Sweep Programs Is Credit Negative For Wealth Managers,” in which it said the increased regulatory scrutiny and lawsuits “could lower [wealth managers'] spread-based revenue earned on clients’ uninvested cash balances and increase legal and regulatory compliance costs.”
The pain is going to be spread further among those companies whose business lines are less diversified and balance sheets more leveraged. Moody's pointed more specifically to companies like Osaic, Kestra Advisor Services and Aretec (the owner of Cetera) as being at risk.
The federal funds rate in August is hanging around 5.3%, but wealth managers have largely been paying clients only around 0.35% on sweep accounts to customers with the lowest balances (the numbers rise after that—LPL, for instance, says it pays 2.2% on cash balances above $10 million).
Plaintiffs’ lawyers caught wise to the problem this year and four big companies, LPL, Ameriprise, Wells Fargo and Morgan Stanley, have been dragged into federal court over their sweep accounts. The plaintiffs, who in some cases are seeking class action status, claim that companies are violating their fiduciary duties and their obligation to put client’s interest first under the Securities and Exchange Commission Regulation Best Interest.
Different Tacks
The brokerages are pivoting different ways on the matter: LPL and Ameriprise recently dug in and said they aren’t raising rates on these sweeps, while Morgan Stanley and Wells Fargo have agreed to raise them. Moody’s suggests that the latter two companies were better able to handle the pivot to higher sweep payouts because they’re bigger, more diversified and have less leverage. LPL and Ameriprise, however, are more vulnerable when it comes to scale and diversification.
“Designed primarily for short-term cash holdings, our FDIC-insured cash sweep vehicles prioritize security, liquidity, and yield—in that order,” LPL said in a prepared response to Financial Advisor earlier this month. “We also offer investment options suitable for a longer-term horizon, such as money market funds, CDs, and fixed income funds. This flexibility allows our clients to tailor their investment strategies to align with their risk tolerance and financial goals.”
Ameriprise also said that the short-term nature of the accounts meant the payouts were appropriate. It noted that most of its sweep money was in accounts under $100,000. “Our rates are competitive and we keep the appropriate level of cash that’s necessary to operate,” said Walter Berman, the firm’s CFO, in a late July earnings call.
Indeed, the companies’ transparency on their sweep rates works in their favor, but that might only hold up as a defense for so long. As rates have risen, more clients have been asking that their money be put in CDs and money market funds, which have higher yields, in a switch known as cash sorting.
“The typical default option is the FDIC-insured bank sweep," Moody's writes, "offering the client a lower yield than money market funds, but with FDIC insurance; wealth management firms typically earn the most spread-based revenue from this option.”
The agency also said, "Cash sweep revenue is particularly profitable because it typically does not accrue financial advisor compensation. ... Cash sweep rates have to date been more insulated from competition than wealth managers’ advisory and commission fees.”
The bump that these companies are getting from cash sweeps is obvious in several ways. Net interest income—which includes cash sweeps—has given LPL a cascade of cash on its balance sheet: The firm said in March that its net interest income had more than doubled from the year before, rising to $159.4 million for the year. Two William Blair analysts said in a July research note that LPL could lose $380 million in spread income if they were forced to raise sweep rates to the same levels other institutions pay.
Wells Fargo conceded it would take a $350 million reduction in net interest income by raising its sweep rates.
“Moves by larger firms to shift rates paid to clients significantly above the peer median on accounts for which they have a fiduciary standard of care will likely drive peers to follow suit,” Moody’s wrote. “We believe that a potential decline in spread-based revenue poses a particularly prominent risk for highly leveraged wealth managers that rely more heavily on this revenue source to service debt.”
And companies like Osaic and Cetera have indeed been ramping up leverage to fund their acquisitions of competitors as a shrinking number of broker-dealer advisors forces firms to acquire more talent by buying it. Osaic was eyed by ratings agencies last year after it borrowed to buy Lincoln Financial, and Cetera after it purchased Avantax.