Cheap Money May Cost Discount Brokers

E*Trade Financial got $10.3 billion a day on average from client brokerage accounts in the third quarter of 2006, the latest quarter for which numbers are available. On that huge amount of money, it paid a minuscule 0.87% on average.

This cheap money was the largest single source of funds for E*Trade that quarter. It accounted for nearly half of E*Trade's $22.3 billion deposit base. So costs would go up considerably if clients wised up and refused to accept that embarrassingly low 0.87%.

How much? Assuming E*Trade had to pay a conservative real-world rate of around 4% for the $10.3 billion, costs would have gone up by about $80 million. That's more than half of E*Trade's reported $153.3 million in net income for the quarter. E*Trade's losing half of its net income would cause serious damage to its shares, in my view.

Just like Ameritrade, a good piece of E*Trade's expected growth this year comes from a growth in discount funding from this cheap cash bonanza. Standard & Poor's analyst Matthew Albrecht says E*Trade hopes to increase customer cash and deposits by more than 30% in 2007, one reason he has a "strong buy" rating on the stock.

Charles Schwab's Potential Damage

Because Charles Schwab has the most generous default rates, it would suffer the least. The brokerage paid clients 2.56% on average daily balances of $16.8 billion in the third quarter of 2006. Schwab earned about 5.1% by investing the money.

Had Schwab paid 4%, costs would have gone up by around $40 million, or 16% of its reported $266 million in net income.

Will Customers Demand Better Rates?

The key question for these brokerage stocks is whether customers will wise up, opt for better interest rates and turn off the cheap money spigot. Connie Bugbee, managing editor of iMoneyNet, believes brokerage customers earn the lousy rates because of sheer "laziness or complacency." She notes that all the details on what brokerages pay are clearly spelled out in account paperwork. "Short of having a parade and a loudspeaker, I don't know what else can be done," she says.

Another factor could also work in favor of the brokerages, speculates CFRA's Puwalski. While the loss for any individual may be relatively small, taken together it all adds up to big bucks for the brokerages. "It's usually just the excess cash between trades," says Puwalski. "If it is a bunch of customers losing $50 a year, what is the likelihood of anyone ever caring?"

But keep in mind that because so many clients are regularly on margin, the number of people with running cash balances may be concentrated, so their losses could be significant. Plus, this is the corner of the stock market where brokerages compete by shaving a few dollars off commissions. If customers are that price sensitive on commissions, it's not a stretch to think they would pick up the phone to make a change that could save them several hundred dollars a year. That's a big risk worth monitoring if you own online brokerage stocks.