The second quarter is over and banks have announced their loan-losses. So what is a loan-loss provision, and how does it affect a bank’s financial results?
When a bank loans money, it records as income the interest payments as they come due; even if the borrower misses a payment or two, the bank still expects to get those installments.
But the bank knows, or can estimate, that some percentage of borrowers won’t repay their loans in full. So the bank sets aside a chunk each quarter representing the loans it thinks will eventually go bad; that chunk is the loan-loss provision.
Each quarter’s provision is added to the bank’s total allowance for loan losses, which sits on the asset side of its balance sheet. When the bank concludes it’s not likely to be fully repaid, the loan is charged off, or subtracted from the allowance.
Accounting rules give management much leeway in deciding how much to set aside. Because the loan-loss provisions directly reduce reported profits, there may be a temptation to skimp on them. But if more loans go bad than the allowance can absorb, the bank may have to raise additional capital from investors.
Deposit brokers sometimes negotiate special deals on bank-issued certificates of deposit, but these CDs can be complex and may carry more risks than traditional accounts sold directly by banks. Here’s how to tell if a brokered CD makes sense for you. Source: FDIC Consumer News
You’ve probably seen ads or gotten phone calls or e-mails from brokers saying they’ve negotiated great deals on federally insured CDs—certificates of deposit—that can mean higher returns than you’d get on your own from a bank. Sounds like a great deal, right? Well, it may or may not be, depending on the offer itself and your personal investment goals.
Generations of Americans have known the CD as a simple, safe, reliable investment for their hard-earned money. With a traditional CD from an FDIC-insured bank or savings institution, if you keep funds in an account for a set period, generally from three months to five years, you get all your money back plus fixed-rate interest payments that are higher than those for regular savings accounts. The guarantees of FDIC insurance, a fixed interest rate, and no loss of principal make the CD especially attractive to consumers who don’t want to take chances with their money.
Yes, brokers sometimes can negotiate a higher interest rate on a bank-issued CD because they can bring a large amount of deposits to the bank. But, CDs sold by brokers can be complex and may carry more risks than traditional CDs sold directly by banks, especially in terms of your ability to lock in an attractive interest rate or get your money back early.
Example: The broker may say that if you need your money before the CD matures, the firm will purchase your CD back without an early withdrawal penalty. While this feature may sound attractive, the buy-back offer probably means that the broker would attempt to find someone else to buy your CD at the going market rate. If interest rates on new CDs have increased above the rate your old CD pays, your broker would try to find a buyer by selling your CD at a discount—a loss to you that could be more than a bank’s early withdrawal penalty, perhaps even resulting in a loss of some of your original deposit.
“Before you invest in a CD through a broker, you need to understand the terms and be comfortable that the CD the broker is offering fits your needs,” says Kathleen Nagle, a Senior Consumer Affairs Specialist with the FDIC. “Otherwise, you could find yourself unpleasantly surprised when you realize that the CD you purchased from the broker isn’t what you thought it was, based on your past experience buying CDs from your local bank.”
Adds Kate Spears, an FDIC Consumer Affairs Specialist: “Unfortunately, we’ve found people entering into transactions without asking the important questions simply because the investment was identified as FDIC-insured.”
How to Choose Wisely
If you’re thinking about purchasing a brokered CD, FDIC Consumer News offers these tips to help you make sure you know what you’re getting and that it’s appropriate for you.
1. Make sure you’re dealing with a reputable broker.
A deposit broker can be anyone from one person working alone from home to someone affiliated with a major financial services firm. There is no federal or state licensing or certification process to become a deposit broker, and the FDIC does not examine, approve or insure deposit brokers. Given the complexity of brokered CDs and the potential risks—and the fact that there have been a few cases reported of unscrupulous deposit brokers allegedly misleading or defrauding investors—consider these precautions.
First, try to deal with someone you believe will only recommend investments that are appropriate for you, and will try to answer your questions and resolve your problems. For a brokered deposit, your best bet may be a financial professional you already know and trust, such as a stockbroker or financial planner with whom you’ve had a good, long-term working relationship.
But, what if you’re thinking about an offer from an unfamiliar deposit broker or company? Independently check on the broker’s credentials and reputation for honest dealing. You’ll want to find out about the broker’s work experience and any history of actual or alleged misconduct by the broker or his or her firm, as evidenced by disciplinary actions by government regulators, consumer complaints about unfair or improper conduct, and similar information. Perhaps the easiest way to get this information is to call your state government’s consumer protection office, which will be listed in your local phone book and other directories, often as part of the state Attorney General’s office. If that office doesn’t have the information you’re looking for, ask to be directed elsewhere, perhaps to the state securities regulator or the office that generally licenses businesses in your state.
And, while there is no licensing requirement to be a deposit broker, we suggest that you find out from your state government if the broker or brokerage firm you’re considering is authorized by the state or federal government to do other business in your state, such as sell securities to the public. The fact that a deposit broker isn’t officially licensed in some other field doesn’t mean he or she isn’t reputable. But, a deposit broker who is licensed in another profession comes under government regulation or industry oversight that “provides a higher degree of assurance that the deposit broker is legitimate” even though this regulation or oversight has nothing to do with deposit-brokering activities, says Christopher Hencke, an FDIC attorney. “Remember, someone who’s not licensed or registered may not be regulated at all, for all intents and purposes, and that’s why it may be riskier sending money to that person.”
These steps will help you “collect enough information to obtain a comfort level to proceed or a discomfort level not to proceed with a deposit broker,” says Karen Currie, a fraud examiner with the FDIC.
2. Understand the potential risks and rewards of a brokered CD.
Ask questions and read as much information as possible about a CD’s terms and conditions, especially regarding the fine print. “Don’t solely rely on the broker’s oral presentation or mathematical calculations,” adds Currie. Here are some of the basic details we think you’d want to learn before agreeing to buy a CD from a broker:
• Can the bank “call” (redeem) the CD early? Your ability to lock in a good interest rate for a long time is restricted with a callable CD. Why? If interest rates fall, the issuing bank may call the CD—give you back your money (plus accrued interest) as soon as possible—so it can reduce expenses by issuing new CDs at the lower interest rates. (Note: Call features may appear in some CDs offered directly by banks, but call features are more common with brokered CDs.)
• Do you understand the difference between a brokered CD’s call period and the maturity date? Don’t mistakenly believe that because of the call feature you have the option to redeem the CD early without paying for that privilege—only the bank has that option. A 20-year CD that’s callable after one year still is a 20-year commitment for the consumer. Vincent Filippini, an FDIC fraud investigator, also notes that regulators have received complaints that “some elderly investors—people in their 70s or 80s—committed to 15- or 20-year CDs thinking they were purchasing very short-term CDs.” He adds that “some seniors are vulnerable to high-pressure sales tactics and may be easily confused about what they are investing in.”
• What would happen if you need to withdraw the CD prematurely, and how much could that cost you? If you have your own CD through a broker, you should be able to pay an early withdrawal penalty to the bank and get your money back. But, if you are sharing your CD with other customers, the broker would have to find a buyer for your piece of the CD. And, as mentioned before, if interest rates rise the broker might sell your CD at a loss for you, maybe even taking away some of your original deposit. “Don’t assume that the broker will pay you approximately the same as you paid for the CD or maybe even a little less,” says Beth Corbin, an FDIC bank examiner based in Harrisburg, PA. “I know of one situation where the broker offered only about 75 cents on the dollar for several CDs that had been purchased for $134,000 during the prior two years—a difference of $33,000.”
• Can the interest rate on the CD go down? If it’s a variable-rate CD, be sure you know when and how the rate can change. There may be, for example, a “step-down” feature, where the interest rate starts off high but continues to decline the longer you own the CD. “The initial rate may be attractive but when you figure in the step-down rate, you may be getting less than what local banks are offering directly with a traditional, fixed-rate CD,” says Corbin. Or, if the interest rate is tied to an index, such as a measurement of the stock market, you may be taking a chance that the interest payments could fall dramatically… or even completely evaporate. “You could even have a 10-year CD that paid no interest at all, not even a penny, if there’s been no growth in the stock market at the end of those 10 years,” says Hencke.
3. Make sure your deposit is fully insured.
If full FDIC insurance coverage is important to you—to protect you from loss in the event of a bank failure—we suggest you take these precautions.
Get the name of the bank or savings association where your money is to be deposited. With this information, you can verify that the bank is FDIC-insured. (Call the FDIC’s consumer affairs staff or search the FDIC’s database of insured institutions at Is My Bank Insured? on the Internet.) You’ll also learn if the broker plans to put money into an institution where you already own other deposits. This is important to know, because the combination of the brokered CD and your existing deposits could push your total deposited funds over the $100,000 insurance limit. (If you think your funds would exceed $100,000, contact the institution to discuss possible options for staying fully insured, or call the FDIC for additional information about your coverage.)
Also, insist that the broker give you a copy of the exact title of the CD issued by the FDIC-insured bank or savings association. Why? Because if the CD is to be shared by you and many other customers, the deposit broker probably won’t list each name in the CD’s title. That’s permissible, but Hencke says you’ll still want the account records to somehow indicate that the broker is acting as an agent for you and other depositors (such as “XYZ Brokerage as Custodian for Customers”). That way, each depositor can qualify for up to $100,000 of FDIC coverage. Otherwise, the FDIC would treat the broker as the owner of the CD and insure it only to $100,000 in total, even if the broker pooled the funds of many different depositors into one CD totaling more than $100,000. “If the broker refuses to provide you with documentation reflecting the title, you should not entrust your money to the broker,” Hencke says.
On this topic of account records, Martin Becker, an FDIC official who specializes in failed bank matters, offers another reason for dealing only with a reputable broker. He says that if the bank that issued the CD were to fail, the FDIC must receive specific information from the broker in order to determine the insurance coverage for the account. “The sooner the FDIC gets this information, the faster we can send deposit insurance checks to the broker,” Becker says. He adds that because interest payments on the CD stop the day the bank fails, “the timely receipt of this information from the broker is even more important to the consumer.”
Final Thoughts
Before purchasing a CD from a depository institution or a broker, shop around for the best combination of interest rates, minimum deposit requirements, maturity dates, and early withdrawal provisions. Check with at least three or four CD providers, including institutions you already deal with and trust. When comparing interest rates, be sure you’re looking at the “Annual Percentage Yield” (APY), a uniform calculation method required by federal regulations to help consumers comparison shop.
Also ask yourself if a particular CD makes sense in terms of your financial goals, your tolerance for risk, and your willingness to commit money to a long-term deposit. Make sure that you understand the CD’s features and that you feel comfortable with the investment before you agree to anything. Following this simple strategy will serve you well and assure that your money is safe and secure in the bank—regardless of whether you deposited it yourself or through a broker.
Its been a hectic few days for banks and for businesses that keep cash in excess of $100,000 (FDIC insurance limit). Concerned CEOs and CFOs are withdrawing cash from their primary bank and spreading it among multiple institutions in hopes of not getting stuck with the next IndyMac. To streamline that process businesses may want to consider brokered CD’s.
By definition, a brokered CD is a Certificate of Deposit sold by a middleman or broker. Financial institutions use brokers to market their CDs to help them gain deposits. The rates on brokered CDs tend to be very competitive because the financial institution is competing directly with other institutions for your deposit.
For example, suppose ABC company has $3 million on deposit at their bank and only $100,000 is insured. With a brokered CD purchase, ABC company can simply purchase thirty $100K CDs at thirty different banks and insure the entire $3 million. Brokered CDs are usually purchased in a brokerage account, not through your business banker. CD terms range from 30 days to 5 years.
More information can be gleaned from your banker or investment representative.
Is my bank safe? Its a question I hear frequently these days from sophisticated CEOs and grandmothers alike. Obviously, the U.S. economy is struggling and most banks have suffered heavy losses. There are lots of opinions and many people pointing fingers. So here’s a simple layman’s guide to understanding your bank: Yahoo Finance.
Yahoo Finance is free and is an invaluable source of information. At the top left of Yahoo Finance, type in the name of your bank and a stock symbol will automatically appear, click on it. For example, lets look at Washington Mutual (WM). The first page of WaMu on Yahoo Finance shows the stock price, market cap, a graph which can be customized to show different time frames, and more. The menu bar on the left has many options, but a personal favorite is “Key Statistics”. In Key Statistics, I usually go straight to down to the Balance Sheet to look at the Total Cash and Total Debt. Its a little shocking to see how much more debt to cash WaMu carries, but other banks like Wells Fargo, Bank of America and Wachovia also carry more debt than cash. A noteable exception is JP Morgan Chase (JPM) which currently has 747.76B in cash and 491.56B in debt. Good job Chase! The same research can be done for publicly traded community and regional banks.
For businesses and consumers with deposits exceeding FDIC-insurance limits, you may want to consider spreading your cash among multiple institutions.
