Bank Profits Pick Our Pockets

Includes: GS, JPM, MS
by: Thomas Tan, CFA

There is a very interesting article “Wall Street profits from trades with Fed”, published at Financial Times’ website Sunday night. It confirms my long time suspicion on the reality and truth about “profit” announced by a few major Wall Street banks these days. As we all know, most of their profit is now coming from the so-called “trading” area. This FT article demystifies at least partially what they are, and where they are coming from. They are actually coming from the Fed, since now the Fed is their largest customer (not the public). So it is the trading profit generated within this shadow banking system, or playing games among themselves.

Due to regulation of required transparency, Fed has to announce beforehand their intention to buy certain securities. This gives plenty time to these major Wall Street banks to first load up these securities, and pump up their prices so they can sell them to the Fed later at inflated prices and book profits that way.

If this is not enough, besides the advanced information, Wall Street also has pricing power. Since a few large players like Bear Stearns and Lehman are out of the way, there are fewer players left in the field for the Fed to deal with, a situation of diminished competition. With now onlya few Wall Street banks in this unfair playing field loading up these securities, they demand and control the prices, and liquidity suffers. The spread of these securities is getting wider, so these Wall Street banks are not only making money from the inflated prices, but also from the spreads.

Bonuses have been a really hot topic everywhere these days. The argument from Wall Street is that now they are making great profits, so they need to reward their employees. One of the Wall Street Journal articles put this into perspective, and indicated “Six of the nine banks paid out more in bonuses than they received in profit,” and “one in every 270 employees at the banks - [a total of 5,000 employees] –received more than $1 million.”

According to the report by New York Attorney General Andrew Cuomo, Goldman Sachs (NYSE:GS) is on course to pay $20 billion in bonuses in 2009 — an average of $700,000 for each and every employee. Morgan Stanley’s (NYSE:MS) bonuses are up 30%, to an average $340,000. At J.P. Morgan (NYSE:JPM), the incentive pool for the first quarter alone has skyrocketed by 175% to $3.3 billion. All these are happening at the worst economic time and amid a crisis caused by the Wall Street banks.

Not to mentioni that the bonuses were a third larger than California’s budget deficit. Since the Fed has dumped trillions in taxpayers’ money to save a few of these banks, maybe as a nice gesture they might return the favor to fill at least a third of the budget deficit black hole in California, which is world’s 8th largest economy?

Keep in mind, each trade has a winning side and a losing side. If these few Wall Street banks are making all the “profit” these days by trading with the Fed, where is the Fed’s money coming from? Who is paying these bills? The funniest thing is that the Fed is actually happy to let these few banks go on gaming the system since they see this approach is a great way to “save” them by funneling the Fed’s money to each bank’s profit/loss statement. Finally the Fed can say to us all “See, the banks are now in great shape! What a great job we have done!” This is why the whole TARP act has been so ill-fated from the very beginning. It is basically ripping off the public, or the taxpayers, to save a few rich bankers.

According to the FT article, a former official of the US Treasury and the Fed said the situation had reached the point that “everyone games them. Their transparency hurts them. Everyone picks their pocket.”

Maybe it more appropriate for him to say "picks OUR pocket."