For investors, there is no free lunch
— -- You're gonna have to learn your clichés. You're gonna have to study them, you're gonna have to know them. They're your friends. Write this down: "We gotta play it one day at a time."
— Crash Davis (Kevin Costner) in Bull Durham
Like professional baseball players, investors need to know their clichés. So write this down: There is no free lunch.
If you've invested in brokered certificates of deposit, you may think that old chestnut doesn't apply to you. These bank CDs, sold through brokerages, often pay a higher interest rate than you can get buying CDs directly from a bank. And since they're federally insured, you won't lose any money as long as your deposit doesn't exceed federal insurance limits ($100,000 for most accounts).
But as several recent bank failures have demonstrated, there are drawbacks to brokered CDs. And with analysts predicting a rise in bank failures in the months to come, it's important to understand what you're giving up in exchange for a higher interest rate.
When the Federal Deposit Insurance Corp. closes a bank, most customers with federally insured deposits have access to their money by the next business day. Customers with brokered deposits, though, may have to wait days or even weeks to get their money.
In May, for example, Pulaski Bank & Trust of Little Rock acquired ANB Financial of Bentonville, Ark., but left about $1.6 billion in brokered deposits with the FDIC. Some customers had to wait up to four weeks to get their money from the FDIC. In the interim, their deposits didn't earn any interest.
When the FDIC closes a bank and sells its deposits to another institution, it gives the acquirer the option of excluding brokered deposits, says David Barr, spokesman for the FDIC. Banks are often unwilling to buy a large amount of brokered deposits, he says, because the investors who hold them will probably take their money somewhere else once their CDs mature.
When the acquiring bank leaves brokered deposits with the FDIC, the agency needs to review brokers' records to determine how much of the money is insured before it returns the money to investors. This process can last a few days to several weeks, depending on how long it takes the brokers to get the necessary paperwork to the FDIC.
In the case of IndyMac, which was closed on July 11, the FDIC has returned about $5.7 billion of the bank's $5.8 billion in brokered deposits, Barr says. The FDIC is running IndyMac while it looks for a buyer. The FDIC stopped paying interest on IndyMac brokered deposits on July 11.
When Mutual of Omaha Bank took over First National Bank of Nevada and First Heritage Bank from the FDIC on July 25, Mutual of Omaha assumed all of the banks' deposits, including brokered deposits, says spokesman Jim Nolan. Those customers had immediate access to their money.
But investors who had brokered deposits with First Priority Bank of Bradenton, Fla., which was closed on Aug. 1, will have to wait for their money. SunTrust Bank bought the insured deposits of First Priority but left the bank's brokered deposits with the FDIC.
Only about $5.3 million of First Priority's estimated $214 million in insured deposits were brokered deposits, according to the FDIC.
Warning signs
Brokered CDs allow banks to attract more deposits without raising rates on all their CDs, says Robert Ellis, senior vice president for Celent, a research and consulting firm for the financial services industry. Quietly offering a higher rate for brokered CDs, he says, is "cheaper than getting into a rate war with a bank down the street."
But a high volume of brokered CDs is a possible sign of trouble, Ellis says. Though brokered deposits can provide a troubled bank with a quick infusion of cash, Ellis says, "It's hot money. It can roll out as quickly as it rolls in."
Brokered CDs accounted for about 30% of deposits at IndyMac and more than 75% of deposits at ANB Financial.
Savers who are interested in investing in a brokered CD should check the financial health of the bank before investing. When brokered deposits account for more than 25% of a bank's deposits, Ellis says, "That's a red flag."
Trouble is, banks that are short on cash sometimes ramp up their brokered deposits quickly, and that may not be reflected in their most recent financial statements, Ellis says. That's why it's important, he says, to work with a reputable broker or adviser who has researched the bank's financial health.
Sandra Block covers personal finance for USA TODAY. Her Your Money column appears Tuesdays. Click here for an index of Your Money columns. E-mail her at: sblock@usatoday.com.