Community Banks, Victims of Investment Fraud?

 

In the past few years, we have seen a trend involving relatively “sophisticated” investors, actually community banks, being taken advantage of by their investment banks who are managing their multi-billion dollar bond portfolio. The scenario goes like this…

The community bank sees its loan revenues declining due to economic conditions, tightened lending restrictions, squeezed margins or a number of other factors.  Since the bank has excess funds to invest, due to declining loan demands, they turn to their investment bankers, i.e., their stockbroker, to see if they can squeeze some additional revenue from their multi-million dollar bond portfolio.  Oftentimes, the community bank personnel and officers lack the professional experience and tools necessary to intelligently invest, or especially trade in the bond markets, so they rely completely on their trusted financial advisors to take care of them.  The financial advisors and broker-dealers are glad to offer their assistance.

So, the community bank follows the lead of their trusted advisors and begin to actively manage, i.e., trade their municipal, corporate and government agency bond portfolio.  On the surface, thinks appear good – the banks portfolios are generating capital gains by selling the bonds at higher prices than they paid.  It appears so good, that the person(s) at the bank in charge of the bank’s investment portfolio falls in love with the stockbroker for making the bank so profitable.  So what’s the problem?  The answer to that question involves a much closer look, a vantage which many, if not most, community banks are incapable of viewing.

Only upon review of trading records does the bank begin to learn that while its portfolio is making some money, its broker-dealer and financial advisor are making much more.  We have seen situations where a bank’s multi-million dollar bond portfolio generated one or two million dollars in profits, where the investment bank made over seven million dollars without risking a cent!  How can this be?  When an investment bank trades a bond – say a $1 Million piece of Fannie Mae – the brokerage firm generally acts as the middleman in a principal transaction.  It works like this.

The investment bank tells Client A, perhaps another small bank or business, that it has found a million dollars of fantastic 4.5% Fannie Mae bond for a slight premium of $100.50 and recommends that Client A buys it.  Simultaneously, the brokerage firm is recommending its other client, say the commercial bank that it is time to sell the same Fannie Mae bond for say $99.00.  Bank is enticed to sell because broker points out that it only paid $98.50 for the bond six months earlier (which increased in value largely due to a declining interest rate environment).  So Bank makes 50 cents per bond (which trade in increments of $1,000, so $50,000 on the transaction), while its trusted broker-dealer makes $150,000 ((100.50-99.00) X 1,000 bonds)) on the deal without risking any of its capital.  The broker-dealer who simultaneously purchases and sells the bond in a matter of nanoseconds makes $1.50 cents on the markdown (purchase from Bank) and markup (sale to its Client 1).  This is known as a riskless principal transaction.

The broker-dealer then advises the Bank to invest the $990,000 of proceeds from the Fannie Mae bond in a 4.25% Freddie Mac bond for $99.00, which the firm simultaneously purchases from Client 3 for say $98.50.  Now multiply this transaction by thousands of transactions over a few years and you begin to see the whole picture.  The Bank trades a 4.5% bond for a 4.25% coupon and books a $50,000 capital gain on the sale of the initial bond.  The .25% interest reduction on a million-dollar bond equates to $25,000 of lost interest a year.  Bank’s bond portfolio is actually worse off, and though it made a profit, the investment bankers made three times as much without risking a cent.  We have seen this scenario played out in the portfolios of several community banks.  How is your bank’s investment portfolio being managed?