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FEDERAL RESERVE BANK
OF NEW YORK
August 23, 1971
IMPROPER BOND TRADING PRACTICES
T o
th e
C h ief
o f e a c h
the
E x e c u tiv e
S la te
S e c o n d
M em b er
F e d e r a l
O ffic e r
B a n k
R e s e r v e
in
D is tr ict:
At tne request of the Board of Governors of the Federal Reserve System, we wish to call
again to your attention the inappropriateness of certain bond trading practices ("overtrading")
described in our letter to you dated August 6, 1968, 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.
We have been informed that the municipal bond industry has experienced a prolifei ation of
securities dealers who employ high-pressure sales techniques and engage in misrepresenta
tion. Many of the new firms engaged in such activities select names similar to olde •, more
established firms or nationally known commercial banks.
For your information, listed below are some of the types of improper bond trading
practices that have come to our attention.
Alfred Hayes,
President.
IMPROPER BOND TRADING PRACTICES BY BROKERS AND DEALERS
1.
Fncouraging "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 (1)
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 "co st" (above
market value). Such transaction has the effect
of (1) 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 purchases bonds at
$100,000
Dealer sells Bank A $100,000 of 4% bonds
due May 1, 1983.
Market Value
^ 92,210
Dealer sells @ $4.00 basis
$100,000
Resume
Bank A sells a 3% yield and purchases a
4% yield, covers up a market loss
and gets new bonds at par.
Sales Advantage — Improves c?sh flow
from interest by 100 basis po’ its.
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 in
flated 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. More
over, bonds purchased should be recorded on
a bank's books at actual market value.
(Over)
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 as
sessment bonds; or selling obligations of
author ties that are not backed by general
taxing power.
4. Misrepresenting firms by posing as a
salesman from a reputable bank or broker
because of similarity of firm name.
5. ” Confirming" sale ofbondstothebank
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 a sale by having the first
firm offer at an extremely high price, then
having successive firms show the bonds at
reduced prices — which misleads the cus
tomer into believing he is obtaining a markeddown value when in actuality the binds are
well above the market.
@FedFRASER