If your exchange account isn’t in a separate account, do you know what it’s invested in? Last week one of the largest title companies in the United States filed for bankruptcy. While that may not be surprising is this time of trouble for the real estate industry, what was surprising to most people is that this was a $1.5 billion (with a B!) publicly held company that was brought down by its' 1031 exchange operation.

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

I’m adamantly against pooling, yet most intermediaries pool their client’s money. By pooling, I mean the placing of all the client’s exchange funds into one account. The benefit of pooled accounts is that the intermediary is investing a larger amount of money, and is therefore able to obtain a greater return.

“...what WAS surprising is this was a $1.5 billion (with a B!) publicly-held company brought down by its’ 1031 operation....”

Of course the intermediary is going to keep some of the interest, which is the whole point of pooling to begin with. In fact, the more the account earns, the bigger the spread – the amount of money they keep. The intermediary’s spread is influenced by two factors: the balance in the account, and the interest rate the account earns.

The very real and obvious incentive is for the intermediary to maximize the amount of spread the pooled account earns. As we all know: the greater the yield, the greater the risk. Now, don’t get me wrong; I am not saying these intermediaries go too far out on a limb on purpose, or that they even think or know, there is any risk in what they are doing. Yet there may very well be greater problems in their investments than even they know about. And if they DO know, they certainly aren’t going to tell you.

Let’s assume that the entire account is invested in a so-called money market account. I say so-called because there are different types of money market accounts (how many of you even knew that?). So what the intermediary thinks is a true money market account may be, in fact, something entirely different. The SEC limits the investments of a true money market account to short-term instruments that mature in less than 13 months, with the average maturity of the fund less than 90 days.

But then there are enhanced money market funds which are allowed to invest in other types of securities in order to ‘enhance’ their return. Some typical examples of enhancements are asset-based commercial paper. Asset based means investments that may very well hold sub-prime loans and could be worth pennies on the dollar. Another common investment in these funds are structured investment vehicles: entities that issue commercial paper. Currently they’re having trouble selling new paper, which brings into question their ability to pay off their outstanding paper. What happens to the outstanding paper held by an enhanced money market account if the entity can’t pay it off? It means your exchange proceeds have just vaporized – even though they were invested in a money market fund.

So what intermediary would be so foolish as to use enhanced money market funds? Unfortunately, many have indeed invested their clients’ exchange proceeds with such “safe” big-name companies as Legg Mason, Sun Trust, Wachovia, Bank of America, Northern Trust and the Janus Funds – all of which have recently had to put money into their money market funds to keep them solvent (even though they are not legally required to do so).

Not all of the big names have stepped up to take care of the problems in their own funds. The Community Bankers Mutual Fund money market account and General Electric’s Asset Management account both closed and paid investors only 96 cents on the dollar. The State of Florida, which operates an enhanced money market account for those communities which have excess property tax funds to invest, recently suspended withdrawals completely. It didn’t have enough liquid cash because of problems with the enhancements in their fund.

Wait, it gets worse. There is also an investment vehicle called Auction Rate Securities, which are long-term maturity vehicles that until recently had weekly auctions where purchases and sales were transacted and interest rates were adjusted. These auctions have ceased, making these securities unmarketable. Prior to the halt of the auction, ARS’s were marketed as essentially the same as cash. Now they’re worthless. This is what the title company’s pooled exchange account was invested in, and which ultimately brought down the company.

Interestingly, one of the most common responses many of the intermediaries (including the one that just filed for bankruptcy) offer when asked about possible problems with their pooled account is “we’re too big to have problems with our account.” Oh really? Bigger than General Electric? Bigger than the State of Florida? Or Enron, WorldCom, Bear Stearns, Countrywide or AIG?

Pooled accounts can bring down even billion dollar companies – remember that the next time you let your intermediary pool your money. Instead, make sure that your exchange funds are in their own account, and that the name of the account includes your name and the words “for the benefit of,” in order to make it clear that they are your funds. You may earn less interest, but at least your funds will be secure.