CD Rates Refresher Course – Brokered CDs

A brokered CD is a CD that is sold through an intermediary, usually a brokerage firm, rather than directly by the bank or savings institution itself.  Brokered CDs are issued by banks but are made available to the customers of the deposit broker.  Some banks, besides providing CDs directly to their customers, broaden the number of customers they can reach by number and geographically, by offering CDs in large blocks to brokers.  The brokers then resell the bank CDs to their clients.

The brokered deposits or CDs are still legal obligations of the issuing bank.  These CDs operate very similarly to regular bank CDs, the account holder agrees to keep their money deposited for a specified term, and a bank agrees to pay you a defined rate of interest.  The CDs that are issued to the brokers are generally issued in large denominations.  The brokerage firms then divide these bank CDs into smaller denominations for resale to their customers.  Most of the deposit brokers are securities brokers registered with the Securities and Exchange Commission such as such as Fidelity, Vanguard and Charles Schwab to name a few.  Other deposit brokers are subject to regulation by different regulatory bodies or may not be subject to regulation at all.

Some measurable differences with brokered CDs is that the terms are generally longer and unlike a bank bought CD, a brokered CD is marketable on a secondary market.  The CD terms for brokered CDs do not have to be longer, they often range in maturities from three months to 20 years.  Along with the higher CD rates that come with longer term bank CDs, long term CDs often have call features.  Some brokered CDs are still similar to bank CDs with terms of less than five years, but other broker CDs can mature from 10 to 20 years.  These longer maturity CDs will frequently have a call provision.  The call provision on the CD means the broker can cash out your CD after a specified period of time, usually one year, and return the initial investment plus any accrued interest.  Bank CDs will usually be called when rates decrease and the bank can reduce their costs by calling in higher rate CDs and replace them with CDs that are at a lower rate or cost to the bank.

Added liquidity is offered by the ability to resell the brokered CDs.  A secondary market fro resale is an important difference between brokered CDs and bank CDs.  Brokered CDs trade in the secondary market at prevailing prices established by the brokers, which may be more or less than the original investment.  Most large brokers maintain a secondary market in these CDs by matching sellers and buyers but they are not obligated to do this.  This means the brokered CDs are negotiable and the CDs can be bought and sold between investors with broker or dealers acting as intermediaries.  Any fixed income security, including a bank CD, sold prior to maturity may be subject to a substantial gain or loss.  When a brokered CD is sold prior to maturity, the CDs are sold on the secondary market subject to market conditions which will impact the price or the amount of funds  the CD holder will receive upon sale.  This is known as interest rate or market risk, and it should be a major consideration for those interested in long term brokered CDs.
Keep in mid that the FDIC insurance on bank CDs flows through to the owners of the individual interests and those interests are subject to the same limitations as CDs that are purchased directly at a bank.  Because federal deposit insurance is limited to a total aggregate amount of $250,000 for each depositor in each bank or thrift institution, it is very important for bank CD account holders that purchase brokered CDs know which bank or thrift issued the CD.  The FDIC insures your total deposits at a single institution.   In other words, find out where the deposit broker plans to deposit your money to make sure of the soundness of the bank as well as to make sure the CD accountholder has exceeded their FDIC insurance limit by having multiple accounts with the same bank.  Also be sure to ask what record-keeping procedures the deposit broker has in place to assure your CD will have federal deposit insurance.

The allure for the issuing banks is that the banks use the CD money for liquidity needs, primarily to fund loans.  Banks use a variety deposits types as a funding source for lending activities, but brokered CD funds can be obtained much faster and in much larger amounts than it would take to market a bank CD directly to consumers.  Regulators can often be concerned about these funding sources when a bank relies too heavily on brokered deposits over traditional core deposits.  If a bank aggressively prices its broker deposits, which is not uncommon, the bank may get squeezed on its profit margin because it’s paying out a higher rate for these CDs and is either chasing higher rates on risky loans or is working with a lower net margin between the costs of funds and lending activity income.  A situation like that becomes even more complicated when the FDIC tries to market a failed bank to other banks, because the buying bank only wants the core deposits, not the brokered ones.  Because of this, poorly capitalized banks will normally be restricted from buying new brokered deposits by the FDIC. 

It is important for bank CD investors to compare the features and benefits of each investment alternative to determine which is most appropriate based on their savings objectives.  Before someone buys a brokered CD, it is imperative to understand all the terms and conditions that apply regarding the CD.  In addition, it is imporatnt to investigate whether making a direct bank CD investment would offer a better rate and better terms, which can often be the case.

Tags: Banks, brokered CDs, CD rates, FDIC

This entry was posted on Monday, February 2nd, 2009 at 4:04 pm and is filed under Money Rates. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.