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F ederal
reserve
Ba n k
DALLAS, TEXAS
of
Dallas
75222
Circular No. 71-202
August 2 b , 1971
To the Chief Executive Officer of the State Member Bank Addressed
in the Eleventh Federal Reserve District:
The purpose of this Circular is to call again to your attention
the inappropriateness of certain bond trading practices ("overtrading")
described in our Circular No. 6 S - l6 b dated July 30, 19&8, and to alert you to
other improper bond trading practices that have recently been reported.
The incidence of such activities involving both State and national banks is
increasing, and we bring this matter to your attention for whatever action
you deem appropriate.
We have been informed that the municipal bond industry has experi
enced a proliferation of securities dealers who employ high-pressure sales
techniques and engage in misrepresentation. Many of the new firms engaged
in such activities select names similar to older, more established firms or
nationally known commercial banks.
For your information we have listed some of the types of improper
bond trading practices that have come to our attention.
IMPROPER BOND TRADING PRACTICES BY BROKERS AND DEALERS
1.
Encouraging "overtrading" -- Under this procedure, a bank
owning bonds carried on its books at cost but having a current market value
below cost sells such bonds at a price above the market, usually at a price
equivalent to book value of the bonds. The bank then purchases from the same
broker other bonds (often of longer maturity and with a higher yield) at a
price sufficiently above market value to reimburse the broker for (l) loss
sustained on the bonds sold to him by the bank and (2) a broker’s fee. The
bonds are then recorded at the new "cost" (above market value). Such
transaction has the effect of (l) deferring the recognition of loss on bonds
sold by the bank and (2 ) placing new bonds on the bank’s books at a price
above their true market value when purchased.
EXAMPLE
Bank A - holds $100,000 of 3% bonds due May 1, 1976.
Book Value
$100,000
Market Value
95,000
Dealer purchasesbonds at
$100,000
Dealer sells Bank A $100,000 of brfo bonds due May 1, 1983.
Market Value
$ 92,210
Dealer sells @U.00basis
$100,000
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
-2Resume
Bank A - sells a 3% yield and purchases a
yield,
covers up a market loss and gets new bonds at par.
Sales Advantage - Improves cash flow from interest by
100 basis points.
Dealer - Loss on purchase
Dealer - Profit on sale
Dealer’s Net Profit
$5,000
$7,790
$2,790
Deferring losses incurred on the sale of bonds by recording bonds
purchased at inflated prices is an unsound banking practice. When selling
bonds the bank should record any gain or loss realized based on the actual
market price prevailing at that time. Moreover, bonds purchased should be
recorded on a bank's books at actual market value.
2.
Misquoting bond rating, coupon price, maturity and yield.
3. Selling bonds as general obligation bonds when, in reality,
the bonds may be: airport revenue, parking revenue, water or sewer revenue,
limited tax, or special assessment bonds — or obligations of authorities
that are not backed by general taxing power.
U. Misrepresenting firms by posing as a salesman from a reputable
bank or broker because of similarity of firm name.
5. "Confirming" sale of bonds to the bank and attempting to deliver
when the bank had not actually agreed to purchase.
6 . Breaking confirmed trades when the market moves against them or
they are able to sell at a higher price elsewhere.
7. Selling bonds without possession, then breaking the contract
when they are unable to acquire the bonds in the market.
8 . "Tailgating" -- Several firms working in conjunction on
by having the first firm offer at an extremely high price, then
successive firms show the bonds at reduced prices — misleading
believing he is obtaining a marked-down value when in actuality
well above the market.
a sale
having
customer into
the bonds are
Yours very truly,
P. E. Coldwell
President
@FedFRASER