Feature Articles and Resources

• How to Select a Broker
  
• Five Tips for Selecting Broker/Dealers
  
• How to Reduce Risk When Selecting Broker/Dealers
  
• Due Diligence for Selecting Broker/Dealers
  
• Tips for Checking Out Brokers
  
• Sub-prime Mortgage Crisis Affects Local Government Investments
  

• Panel of Economists: Economic Outlook
  
• Interest Rate Outlook
  
• Snapshot of Economy and Interest Rates

• Performance Benchmarks
  • 10-Bill Index
  • Money Market Fund Index
  • LGIP Index
  • Key Rates: Cash Markets
  • Relative Value Yield Chart

How to Select a Broker

By Deanne Woodring, David Westcott, and Sally Walton

This article is designed to provide information on how to choose qualified brokers. It presents a step-by-step process on how to create and manage this selection process. It is important to view this as an ongoing, dynamic process with a need to continually review both the government's changing requirements and the development of new services in the marketplace. Equally important, this effort should be a proactive process that the government (not the broker) initiates and controls.

1. Form a Broker Review and Selection Committee. The selection process begins with the development and formation of a broker review and selection committee. The committee should be comprised of the finance director, any person who works directly with the broker in an investment decision-making capacity, and at least one additional person outside of this direct process. Some governments already have an investment committee that could perform similar duties.

This team should meet formally at least once a year and should report its results to the city council. At each meeting, the committee should review the following:

1. A list of the investment dealers that are currently authorized to do business with the government entity;
2. A review of the audited financial statements of each investment dealer and changes in financial condition that may affect the dealer's ability to perform;
3. A review and analysis of services that are being provided by each investment dealer;
4. A measurement in percentage or absolute dollar amounts that each broker has transacted during the quarter; and,
5. Recommendations made by this review committee for adding or deleting investment brokers from the authorized list.

The purpose behind the establishment of the broker selection and review process is two-fold: 1) to create an active process that will ensure that the brokers who are currently authorized are the most qualified, and that their qualifications are constantly reviewed in a formal and timely process; and 2) to produce a checks-and-balances system that communicates to those with a fiduciary responsibility.

2. Develop Selection Criteria. Subsequent to the formation of a broker selection and review committee, the government should develop criteria regarding financial qualifications and dealer certification of authorized investment dealers. For example, minimum standards need to be established for capitalization and reports received annually from each dealer that confirm the dealer's ability to meet capital adequacy requirements as reported to the Financial Industry Regulatory Authority (FINRA).

Among public-sector investment officials, there has been considerable discussion of whether to restrict their business to those with primary dealer status. However, history has demonstrated that this status does not ensure financial stability or the commitment to providing an investment service that meets your specific investment needs. Each investment dealer needs to be analyzed on his or her own merits and capabilities. Do not let financial size lull you into a false sense of security. Whether the investment dealer is a primary dealer, regional dealer, or bank, the finance officer is responsible for establishing a due diligence process. Make dealer selections on the basis of a commitment to serving the government's needs with the required expertise and financial qualifications.

3. Develop a Broker Questionnaire and Interview Process. Governments should establish a procedure for deciding which brokers will be authorized to do business with the government. This procedure should require that potential brokers apply via a broker questionnaire and then engage in a personal interview. Such a questionnaire would address the following issues:

1. Name of individual or individuals who are authorized by their respective organizations to transact investments with the entity. This authorization should be endorsed by an officer of the firm in writing and updated annually.
2. References from at least three other entities that have investment needs that are similar to the government. Contact each reference to confirm the prospective broker's qualifications.
3. A signed certification that the investment broker has read and agrees to comply with the investment policy of the government.
4. The policy should be sent annually and each broker should review and certify compliance annually.
5. A current audited financial statement will be provided annually.
6. A description of the dealer's individual history of investment experience, registrations, and a disclosure of all past complaints or violations that have been lodged with FINRA.
7. A written disclosure of the distinctive qualities that they or their firm possess which they believe will assist the government in the investment management process. This includes identifying what written reports (e.g., on portfolio analysis, risk management, total return analysis, and swap analysis) will be provided and how often. Have the prospective broker provide an example of the reports that will be provided to the government.
8. The name of their immediate supervisor and his or her phone number. A call should be made to this person to discuss the government's needs and the qualifications of the investment broker.

After this questionnaire has been completed, the government should interview prospective brokers. At this interview the government should discuss its investment objectives and the broker's firm should discuss how it would assist the government to meet its objectives. Upon successful completion of this interview, the prospective broker will be much better prepared to provide services to the government. And more importantly, the responsible finance officers will be in a more knowledgeable position concerning the qualifications of the persons with whom they are doing business.

Deanne Woodring, CFA, and Dave Westcott, CFA, are managing directors and Sally Walton is senior vice president of Davidson Fixed Income Management.

Five Tips for Selecting Broker/Dealers

1. Avoid broker/dealers pushing “exotic” securities. If a broker seems insistent on the latest exotic security, politely say no thank you. Exotic securities can be defined as those securities that have higher yields, greater market risk, and are normally not found in cash management portfolios. Exotic securities have definite problems in the areas of liquidity, wide bid/asked spreads, and credit quality. These instruments have no place in the majority of public cash management portfolios.


2. Be especially wary of those that talk of “fantastic yields.” In most instances, these assertions are either untrue or misrepresented. Remember if it sounds too good to be true, it probably is.


3. Find broker/dealers with special expertise. Some broker/dealers have developed a specialty niche in a certain area of the market, which can be profitable for their clientele. Some broker/dealers constantly analyze spread relationships, overbought/oversold conditions in the market or swap opportunities. Search for broker/dealers with expertise appropriate to the government's needs.


4. Establish a long-term relationship with a broker/dealer. Discuss investment strategy with a broker/dealer face-to-face and make sure the broker/dealer has seen the entire portfolio. Broker/dealers should be familiar with the government's cash flow level along certain areas of the yield curve and among certain investment vehicles.


5. Insist on state regulation. Let the broker/dealer know that the public entity will only do business with those broker/dealers and firms that are registered with the state's regulatory agency.

How to Reduce Risk When Selecting Broker/Dealers

The risks facing public investors who transact business with securities dealers can be categorized as default risk, reputational risk, transactions risk, and misrepresentation risk. Each risk can affect the value of a government's portfolio and seriously jeopardize liquidity.

Default Risk. As the phrase implies, default risk is the risk that the dealer will default on its obligations to the client. Generally, this risk is associated with an insolvency, where the dealer firm's capital is eroded through adverse market conditions that wipe out the firm's trading account and the value of portfolio securities. If a client government has obtained delivery of its securities and acted to avoid the liquidity problems discussed, default by a securities dealer need not jeopardize a public portfolio.

To control default risks, many governments rely exclusively on primary dealers as their business partners, although this strategy is no guarantee. Nonetheless, a certain wisdom can be found in the philosophy of those who select the largest primary dealers for conducting their business, on the theory that such firms would be too big to fail. A second technique used by public sector investors is to insist on capital adequacy as defined by the New York Federal Reserve Bank. Capital adequacy standards offer a quantitative yardstick that can be used in various ways.

A third technique for controlling default risk is to conduct direct credit analysis. Unfortunately, this avenue often yields frustrating results for the public investment official unable to obtain adequate financial information regarding the firm and to measure the risk undertaken. Therefore, most public investors rely primarily on the Federal Reserve capital adequacy standards and certifications surrounding a firm's compliance.

Reputational Risk. Reputational risk is the risk of bad publicity from doing business with a failed firm. Many public investors who successfully weathered defaults by failed securities dealers report that they lost valuable hours of staff time in explaining why they conducted business with the firm in the first place. Therefore, safety of effective delivery procedures, while important, does not eliminate all risks associated with the default of a securities dealer.

Transactions Risk. Transactions risk involves the chance that an investor's liquidity could be jeopardized by failures, whether mechanical or credit-related. Here the risk involves the nuisances associated with wire failures and other difficulties associated with transferring securities and arranging for timely cash movement. Transactions risk also includes the risk of holding securities issued or held by a dealer who is unable to liquidate them because of regulatory or court intervention.

Mechanical failures that are a reflection of inefficient operations need not be associated with financial solvency or creditworthiness. Some securities firms simply are ill-equipped or understaffed to accomplish their function. Others suffer related operational handicaps that preclude reliable deliveries. To minimize such problems, public investors should ask about the fail rate of prospective dealer firms and conduct investigations and reference checks with other public clients.

The risks associated with transactions that might be immobilized or frozen by a regulatory agency, on the other hand, do involve creditworthiness considerations. Here, the primary concern surrounds repurchase agreement transactions and the possibility that a court-appointed receiver or agency might preclude a government from liquidating its collateral, even if delivery is accomplished. Use of proper custodial procedures to accomplish delivery or third-party ownership of highly liquid instruments can go a long way to minimize transaction risks.

Representational Risk. There are numerous ways for an unscrupulous dealer to portray the securities characteristics of a given instrument. Unsophisticated investment officials are easy prey to dealers who can take advantage of the investor's misunderstanding of investment characteristics. Instances have occurred where the loss of public funds resulted from inappropriate investments, excessive price markups, and exotic investment strategies pushed by unscrupulous dealers and factual misrepresentation.

Generally, the control of misrepresentation risk involves three positive actions. First, the government securities investor should obtain a second price quote whenever the real market value of the instrument is in doubt. In the case of Treasury bills and other instruments for which market prices are available through the financial media, the practice of obtaining a second quote may not be necessary because of the highly competitive nature of the market. However, for other instruments, particularly those not quoted in the daily financial press, a second quote should be obtained to verify the market value of the securities. If no second offering is available, then a quote on a comparable offering should be obtained as a way to verify the market value of the securities.

Second, the investor should conduct a complete investigation of instruments held in the portfolio or under consideration. A prudent investor never purchases securities without first investigating the credit risks, market risks, and mathematical properties of the instrument. The historical performance of the instrument vis-a-vis other securities also should be understood before a purchase is made.

Finally, the investment official should specifically and directly ask the offering dealer the following questions (unless the answers are already known):

• If I wanted to sell this security tomorrow and the market does not change, what would be the price available to me?
• Who will be willing to repurchase my securities? (Who makes a market?)
• If interest rates move up by 100 basis points during the next month, what will be the price of this instrument in the open market? (This is not a request for a guarantee, but a way to understand price volatility.)
• Are there any conditions under which it would be imprudent for this government to acquire this security, based on our written investment policies and the needs of our portfolio as we have explained them to you?
• What other public institutions have purchased this instrument from you within the past month, the past year?

These strategies for reducing representational risk cannot replace the first rule of securities transactions: “caveat emptor” (buyer beware). Remember, never be pressured – there is always another chance to purchase an appropriate security.

Misrepresentation in a securities transaction is very difficult to prove in a court of law or other proceedings for recovery, unless the transaction is documented in writing or a tape recording. Some public investors, wary of possible misrepresentation or misunderstanding of the security and investment characteristics of a given instrument, have decided instead to purchase only "plain vanilla" instruments. Fraud cases seldom involve Treasury bills, because most market participants know what they are worth. Public investors should conduct a background check on prospective broker/dealer sales representatives. The Financial Industry Regulatory Authority (FINRA) operates an automated database called FINRA BrokerCheck. Investors also can check with their state regulatory agency.

Due Diligence for Selecting Broker/Dealers

Governments should thoroughly investigate the financial condition and reputation of prospective firms and individual brokers before agreeing to conduct business with them. Investment officials can examine publicly available financial data and annual reports before a relationship is established.

Obtain Financial Reports. Governments can request copies of financial reports that broker/dealers submit to regulatory agencies and associations. For example, members of the Financial Industry Regulatory Authority (FINRA) are required to submit quarterly Focus Reports. Firms also are required to submit 10K reports to the Securities and Exchange Commission (SEC), which can be obtained from the SEC Web site. In addition, governments should obtain information on a firm's registration with FINRA and any citations they may have received.

Commercial banks are required to submit call reports to the office of the Comptroller of the Currency. These reports are available from this Web site . Investment officials can ask the bank to provide copies of the call report, which are available 45 days after each quarter. The information on the call report is published in the Uniform Bank Performance Report and is generally available 90 days after the call report date from the Federal Financial Institutions Examination Council. Independent bank rating agencies also provide financial information for a fee.

Review Financial Data. In reviewing financial data, investment officials should evaluate the firm's profitability and capital positions over time. It is also important to check the financial history of the parent company to ensure its capital is behind the subsidiary. In addition, the auditor's opinion and footnotes to the financial statements should be reviewed with careful attention paid to any contingency footnote that may reveal pending litigation that could be potentially harmful to the firm.

Check Staff Qualifications and Contact Information. Investors must ask for background information on a firm's sales representatives and their supervisor. Many investment losses can be attributed to doing business with unfamiliar broker/dealers or firms. When interviewing prospective firms, officials should ask about the size of the professional staff, including the number of research and credit analysts on staff. They also should obtain information on their areas of expertise and trading activity and determine whether sales or account representatives handle other public entity accounts. It is important to assess a security dealer's experience and knowledge of public funds investing. In addition, it is important to obtain all contact information for the primary contact, backup, and operations staff.

Check References. Government officials should evaluate the prospective sales representative's reputation by obtaining references from federal and state regulators and from other clients. Public sector clients make the best references; therefore, officials should ask specifically for at least four public sector references.

Internal Control Compliance. The government's internal investment staff should make sure that the investments being offered are in compliance with investment policy guidelines. Each dealer should receive a copy of the government's written investment policy and understand that no investments are to be recommended to the government unless they conform to the guidelines. Some governments require dealers to sign a certification form acknowledging that the dealer has received a written copy of the investment policy. In addition, governments should assess whether any potential conflicts of interest exist.

Tips for Checking Out Brokers

Federal or state securities laws require brokers and their firms to be licensed or registered, and to make important information public. But it is up to you to find that information and use it to protect your investment. The good news is that this information is easy to get, and one phone call or web search may save you from sending public funds to a con artist, a bad broker, or disreputable firm. 

Check the Broker's Registration and Record. Before you invest, make sure your brokers are licensed to sell securities. Always check and see if they or their firms have had run-ins with regulators or other investors. This is very important, because if you do business with an unlicensed securities broker or a firm that later goes out of business, there may be no way for you to recover your money — even if an arbitrator or court rules in your favor.

The Central Registration Depository (CRD) is a computerized database that contains information about most brokers, their representatives, and the firms they work for. For instance, you can find out if brokers are properly licensed in your state and if they have had run-ins with regulators or received serious complaints from investors. You will also find information about the brokers' educational backgrounds and where they've worked before their current jobs.

Check if the Broker has SIPC Coverage. Once you've checked out the registration and record of your broker, there's more to do. For example, you should find out whether the brokerage firm and its clearing firm are members of the Securities Investor Protection Corporation (SIPC). SIPC provides limited customer protection if a brokerage firm becomes insolvent — although it does not insure against losses attributable to a decline in the market value of your securities. If you have placed your cash or securities in the hands of a non-SIPC member, you may not be eligible for SIPC coverage if the firm goes out of business.

Ask Questions. Below are several questions to ask prospective brokers:

• What experience do you have, especially with people in my circumstances?
• Where did you go to school? What is your recent employment history?
• What licenses do you hold? Are you registered with the SEC, a state, or FINRA?
• Are the firm, the clearing firm, and any other related companies members of SIPC?
• What products and services do you offer?
• Can you only recommend a limited number of products or services to me? If so, why?
• How are you paid for your services? What is your usual hourly rate, flat fee, or commission?
• Have you ever been disciplined by any government regulator for unethical or improper conduct or been sued by a client who was not happy with the work you did?

This article is adapted from an SEC publication, Protect Your Money: Check Out Brokers and Advisers, 2007.

Sub-prime Mortgage Crisis Affects Local Government Investments

The sub-prime mortgage crisis rocking the world's financial markets has even reached the conservative investment realm of local government portfolios. The investment managers of King County, Washington 's local government investment pool were shocked to find out recently that two of their investments were suddenly downgraded. In fact, one of the investments, a commercial paper fund called Mainsail II, was downgraded below investment grade because it had too many assets in sub-prime mortgages. To prevent King County 's investment pool from being downgraded, county officials quickly pulled the troubled $53 million investment from the $4.1 billion investment pool and put it into the county's portfolio. The county decided that it was worth bearing the risk of this investment in order to maintain the long-term integrity of the investment pool.

County officials have a “high degree of confidence” that they will recover their principal from the troubled investment in Mainsail II. In a worst-case scenario, officials expect that they will receive 85 cents on the dollar, which would be an $8 million dollar loss.

Source: Seattle Times

Economic Outlook

This month, Treasury Management asked its panel of economists what factors are likely to play the most important role in the direction of interest rates over the next six months. We also asked the panelists to provide their forecasts of the economy.

Eugenio J. Alemán of Wells Fargo Bank says that the recent volatility created by the sub-prime issue will continue to influence the markets. However, real factors (such as consumer demand and business investment) will be the main determinants for the growth of the economy.

Lacy Hunt of Hoisington Investment Management states that the most important determinant of long-term bond yields, over time, is inflation. He notes that the year-over-year core inflation rate dropped to 1.9 percent in June, which is down from of a peak of 2.4 percent. Hunt expects this trend to continue. He adds that there is a risk that the economy will be in recession by the end of this year or early in 2008.

According to John Silvia of Wachovia Securities, the factors that will play the most important role in the direction of interest rates are credit liquidity and the economic outlook. Silvia predicts GDP growth of 2.5 percent and CPI inflation of 2.8 percent for the second half of this year. He expects that the Federal Reserve will keep the Fed Funds rate unchanged.

The most recent Federal Reserve Survey of Professional Forecasters predicts moderate economic growth in the months ahead, with GDP averaging 2.8 percent in 2008. The survey predicts that CPI inflation will decline from an average of 3.6 percent in 2007 to 2.2 percent in 2008.