Wednesday, May 2, 2012
Boards of directors are charged with overseeing management’s implementation of various internal controls and policies. But when it comes to large and complex institutions how can the boards be expected to notice all deficiencies?
A moderate size community bank’s investment portfolio was liquidated to create additional liquidity to support its operating capital needs and to allow it to borrow less. In this liquidation, the senior management initially just wanted to liquidate the securities at market or what’s worse at market established by just one broker. In other words, just letting the broker who called to discuss rebalancing the portfolio provide that day’s bids and execute a multi million dollar trade.
You might say: So?! The management knows what they are doing and the brokers will always give a fair bid! This may be the correct assessment some times but not always (actually almost never.)
While a miniscule example, what’s $10 or $15 million to a multi million dollar institution you would say? Well, it may mean a lot. If the bank has not made money for the past 3 to 4 years a difference of $50 to $75 thousand may mean a lot to its bottom line.
The better approach to such a trade would be:
First management should review the most recent security valuation report from the bank’s bond accounting provider. This would provide an idea of the most recent market value for the bonds (by the way most banks can only hold bonds in their investment portfolios).
Next management should assess if the bonds to be traded are used as collateral (some depositors require for their accounts to be secured by bond collateral to some degree) or are part of a repurchase agreement. If so to find other bonds or find out what is necessary to notify the depositors or repurchase agreement administrators.
The following step, management should to determine the true market value of the bonds by either allowing a broker (or a few approved brokers) to list the bonds on the bond trading board (PIC), which would allow the “market” to bid on them. In this move management would have to communicate the desired price to the broker so that when the bonds are listed the open bids are close to target.
Alternatively, management could contact a few brokers and ask them to bid the bonds for their own portfolios. In other words the bond would not get listed in the market. Often the brokers will have other institutional clients looking for bonds in a specific market or by a specific issuer and will be able to provide bids that are competitive.
Once management get an idea of the minimum sell price they should create a report of the possible gain/loss for the full trade. This report should be updated as the bonds sell.
Using this approach for a bond trade management will be organized and accountable for the trade. Additionally the transaction becomes transparent (if reported correctly) to the board and other users of this information by clear documentation of the fact that management in no way forgone the interest of the bank or its shareholders.
But does this always happen? What does your bank’s policy or procedures state about how such trades should be handled?
OCC’s Bulletin 2002-19 Unsafe and Unsound Investment Portfolio Practices: http://www.occ.gov/news-issuances/bulletins/2002/bulletin-2002-19.html