Dear Board of Directors:
Recently, credit unions have experienced increasing problems with brokered certificates of deposit (CDs). These problems have occurred with at least two brokers against whom NCUA has issued “cease and desist” orders. They are San Clemente Securities and Prime Yield. Further, the National Association of Securities Dealers, Inc., (“NASD”) issued a press release on July 21, 2000 announcing it had issued a complaint against San Clemente Securities, Inc., charging fraud and other misconduct in connection with an investment program involving the offer and sale of CDs during the period June 1999 to March 2000. It is possible the problems are not limited to these firms and we are therefore, providing this letter.
Credit unions have occasionally lost money when a financial institution that issued the CD became insolvent. In addition, broker fees paid by the credit union for the CD transaction were not covered by federal deposit insurance. Credit unions have also received low yields on CDs, often below the rates available on investments with similar terms. While no credit union has become insolvent as a result of CD purchases, there is an increasing concern because more credit unions are purchasing CDs without proper understanding or analysis of the instrument and the parties associated with the transaction.
The following are some of the potential CD activities for which you should exercise a higher level of caution and due diligence.
- Purchasing a CD quoted in terms other than bond equivalent yield. See Appendix A for a detailed example of this transaction.
Decisions between investment options are difficult to analyze if yields are not comparable. Bond equivalent yield is the industry convention for comparing yields and should be adopted by you when evaluating investment alternatives. When evaluating zero coupon CDs, avoid yield quotes based on simple interest yields because they will be misleading and appear artificially attractive. See Appendix B for a discussion of bond equivalent yield versus simple interest yield.
- Purchasing a long-term CD as an investment, often at below market rates, as a condition for obtaining brokered deposits with below market rates, often with short maturities. See Appendix A for an example of this transaction.
Credit unions engaging in this practice will experience the loss of the short-term deposits at maturity unless renewed, while continuing to hold the long-term CD/investment. You may also experience an increase in funding costs when new deposits are obtained at market rates that take the place of the maturing deposit. You should avoid such programs as a means for obtaining long-term liquidity.
Credit unions purchasing the shorter-term brokered deposits may be unaware a portion of the interest payment originates from the broker, and is not an obligation of the issuing institution. The below market rate on the long-term CD provides the subsidy necessary to allow the broker to pay market rates on the short-term deposit.
- Purchasing a CD from a broker where the documentation is unclear as to the invested amount and any broker fees, leading you to assume your principal balance is the same amount as the funds wired.
Confirmations will disclose amounts wired which will include the broker’s fees. Misrepresentations have been experienced with CD safekeepers who are affiliated with brokers. Specifically, amounts wired have been referred to as principal amounts, implying that the total wired amount is invested and insured, when in fact the actual principal is the wired amount less broker fees. The difference between your payment and the amount remitted to the issuing institution represents the broker’s income. The amount retained as income by the broker is not an insured deposit. For example, a broker may sell you a zero coupon CD for $60,000 and remit only $57,000 to the issuing financial institution. Only the $57,000 used to actually purchase the certificate is insured, plus accrued interest.
- Using a safekeeper that may be unreliable.
Improper or incomplete disclosures have been experienced with CD safekeepers that are affiliated with the broker involved in the transaction. For federally-chartered credit unions Part 703 of the NCUA Rules and Regulations (§703.60) requires that all safekeepers be board-approved. State-chartered credit unions should refer to their individual state’s statutes. You have an obligation to investigate the reliability and financial soundness of your safekeepers before approval. Further, sound business practices require that a written safekeeping agreement be signed and on file before using a particular safekeeper.
- Purchasing a portion of a master certificate of deposit held in the broker’s name which is also held at the broker’s safekeeper.
When you purchase a negotiable certificate or a portion of a master certificate, the safekeeper should record your security interest. You will not receive a physical certificate. The safekeeper must record you as the beneficial owner on its records. Failing to do so will create ambiguity as to the actual federal deposit insurance coverage and your ability to liquidate the asset. If the safekeeper is not independent from the broker, you should ensure the board of directors has approved the safekeeper and the board is aware this is the least desirable method of safekeeping.
- Purchasing long-term certificates where the broker has “guaranteed” to repurchase the certificate, if requested, prior to maturity at the credit union’s option.
The guarantee is typically not in writing, nor is there any assurance the broker will exist at the time the option could be exercised. When a broker repurchases a certificate, it may be at a price set by the broker rather than a market price. Without written documentation you should not accept these guarantees. In addition, you should not expect that the CD could be readily liquidated without a loss.
- Conduct a thorough evaluation of all brokers, including background, disciplinary history, and reputation, prior to using them for investment transactions.
- Obtain yield quotes in terms of bond equivalent yield.
- Avoid complex broker transactions driven by long-term liquidity needs unless the risks are fully understood and manageable, especially if these transactions take the form described in Appendix A.
- Require documentation from your broker and safekeeper in the form of confirmations, safekeeping agreements, and safekeeping records that are clear and comprehensive.
- Ensure that you are comfortable with the integrity of the safekeeper and obtain board approval prior to placing investment transactions with them. It is preferable not to use a safekeeper affiliated with the broker involved in a transaction.
- Request and obtain from the broker a written statement of the verbal promises and quotes prior to purchase.
- Have a procedure in place to assure you do not place multiple CDs in a single institution if your policy limits CD investment to the insured limit.
- Avoid investments you do not fully understand.
You should review your current CD investments, NCUA’s investment regulation or your state’s regulations if you are state-chartered, Part 703, and your policies and procedures related to brokered CD activity to determine that necessary safeguards are in place. If you have any questions, please contact your district examiner, regional office, state supervisory authority, or the Office of Investment Services.
Norman E. D’Amours
National Credit Union Administration