The Securities and Exchange Commission has rules that prohibit the sale of highly complex and risky securities to "unsophisticated purchasers." By definition, financial institutions are sophisticated purchasers. But are they? When it comes to many community banks, the answer is clearly "no." And too often, intricate and risky instruments, including some loan participations, are sold to these institutions by heavy-handed salesmen from money center banks.
Regulators, for good reason are concerned. Following is an excerpt from an advisory letter issued in late August to banks by David M. Gibbons, deputy comptroller of the Currency for Credit Risk:
Relying on the reputation of a major money center bank, a bank purchased a number of participations in large, syndicated national credits. While the purchased credits helped diversify the bank's geographically concentrated loan portfolio and offered attractive yields, they also introduced significant credit risks that bank management neither understood nor could control.
Several of the purchased loans were subordinate tranches of complex leveraged financing structures, and most of the purchased credits were to businesses in specialized industries with which bank management had little or no lending experience. The repayment of one loan was heavily reliant on optimistic cash flow and enterprise value assumptions for a company in an already troubled industry sector.
When projected cash flows did not materialize, the borrower declared bankruptcy and the enterprise value of the company was significantly impaired. The bank's share of the resulting loan loss exhausted its entire allowance for loan and lease losses.
Gibbons, in a telephone interview, said the example is not uncommon, and stressed that it is the responsibility of banks--no matter their size, or from whom the loan is bought--to diligently assess the quality and riskiness of each credit.
But there's another side, too. Big money center banks have the responsibility to sell their wares to investors who truly are sophisticated enough to understand them. Indeed, the syndicated loan departments of some money center banks have lists of community banks which, indeed, are sophisticated, and don't sell to those that aren't.
We understand that banking no longer is what it was, and that in the rush for super returns on equity, ethics have become increasingly less important. But we question whether such practices are wise. Despite the convenient rewriting of history by those who were eager to dismantle the Glass-Steagall restrictions, it was greedy and irresponsible behavior by banks that led to the so-called Depression-era laws and regulations.
If the money center behemoths turn themselves into the equivalent of boiler room pushers of nasty paper to the corporate equivalent of widows and orphans, ultimately they will bring harsh regulations upon themselves. It is in their self-interest, to run ethical organizations.