Mihalek Law A Securities Arbitration & Litigation Firm
Practice Areas

Avoid Excessive Markups/Markdowns

AVOID EXCESSIVE MARKUPS/MARKDOWNS

If you are a relatively new community bank (de novo bank), or an institutional-sized business without a Bloomberg machine and the staff who know how to operate it, you are at risk to be overcharged on your bond transactions. How can you tell if you're being overcharged? You cannot - not without the right tools, expertise and resources.

If you suspect you are being overcharged, read on; and then call us to discuss how we can help.

Picture this: Your phone rings and on the other end is your friendly, professional financial advisor . . . and he has great news. He has found the PERFECT bond for you. But you ask: "Isn't my account already fully invested?" Yes, answers your broker, but I recommend that you sell Bond A and take the profit and buy a new bond to replace Bond A. Thinking your financial advisor is looking out for your best interests (as an investment professional should) you instruct your broker to make the switch if he thinks it is the right move to make.

So, you sell Bond A for $101.50 for proceeds of $101,500 that you bought at par ($100,000) 4 months earlier for a tidy $1,500 profit; and reinvest the proceeds in the new bond. Since the new bond has the same coupon, maturity, yield and rating as the one you sold, your fabulously savvy broker has magically made you $1,500 and your portfolio remains essentially the same. It's a win, win transaction, right? Well let's compare the "winning".

Typically, investment banks conduct bond transactions on a principal basis. That means the brokerage firm bought Bond A from your account for $101,500. You ask, why would the firm want to do that? The answer is quite simple. The firm has already found a buyer for your Bond A at a price of, say $103.50 ($103,500 total). So on that side of the transaction, you made $1,500 and assumed all of the risk that the bond price might fall during the four months you owned it and the firm and financial advisor split $2,000 of profit on their riskless principal transaction. This is called a "markdown"; and since the trade was done on a principal basis, the firm need not and does not disclose it to you. So, the firm made more than you did in the 30 seconds it took your broker to convince you to sell. Sound fair? Why didn't the firm pay you $103.50 when it bought your bond? But wait, there's more.

When you reinvested in Bond B, you again engaged in a principal transaction with the firm, and you guessed it, the firm marked up the price of the bond it sold to you. It works like this. When recommending the perfect bond to you, the firm already had located the bond and knew it could be purchased at, say $100.25 ($100,250 total). The moment the firm had your authorization to follow the recommendation of your trusted broker, it bought the bond, held it in inventory for a second or less and sold the same bond the bond to you at $101.50 ($101,500 total). So the firm and your broker made another $1,250 on the purchase side of the transaction.

In total, your $1,500 was reinvested in a similar bond so your profit was illusory. However, the firm and your financial advisor made $3,250 on the round trip transaction. So whose interests were served? Many institutional-sized investors have the necessary tools to determine the true market value of a bond (like the price that firms pay when they buy and sell the securities amongst themselves (an inter-dealer trade). One such tool is a Bloomberg terminal and subscription services with costs starting at about $5,000 a month. This allows its users to see in real time all debt security transactions whether interdealer, between to customers (a cross transaction) or between a broker-dealer and its customers (principal trades).

However, many other institutional investors, like small regional banks, and other types of businesses do not have the necessary tools, nor personnel with the skills necessary to utilize such tools to determine the "fairness" of the prices paid and charged by the brokers. These investors are blindly following their broker's recommendations under the assumption that the broker and the firm are putting its customers' interests ahead of its own. Given that debt instrument transactions are a significant profit center for the broker-dealer, and that principal trading costs, i.e., the markups and markdowns, are not disclosed to the customers, that assumption may not be well based. In reality, it may prove foolhardy.

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