Inside Wall Street's Money Machine

Record profits. Record bonuses. Record recklessness. Record ire.

I'm talking about Wall Street, and you've heard it all over the past years. But here's something that doesn't get discussed enough: Without one fairly obscure division inside these banks, there would be no "record" anything. Without this one division, Wall Street would have suffered the same profit blow the rest of the economy did.

What is it? Fixed income trading.

The numbers here are incredible. Last quarter, Goldman Sachs (NYSE: GS  ) derived 58% of revenue from its fixed-income, currency, and commodities division. The same number was 30% for Morgan Stanley (NYSE: MS  ) . At JPMorgan Chase (NYSE: JPM  ) , fixed-income trading made up 20% of revenue. For Bank of America (NYSE: BAC  ) , fixed-income trading was responsible for 18% of revenue, and it was 21% at Citigroup (NYSE: C  ) .

As my colleague Matt Koppenheffer wrote last week, it wasn't always like this. Fixed-income trading has historically been a nice, but by no means overwhelming, part of revenue. In 2001, fixed income made up 26% of Goldman's revenue. Today, it's more than double that.

Why? What's going on here?                         

Blowing bubbles, or the real deal?
Two factors explain the explosion in fixed-income trading: client-driven activity, and a gigantic tailwind courtesy of the Federal Reserve.

There are two subsectors that typically make up a fixed-income trading division. The first is client market-making, where a bank pairs up and clears trades for clients. Say a hedge fund or pension fund wanted to buy a big block of municipal bonds or corporate debt. If a broker like Goldman Sachs can find another big investors willing to sell that debt, it can pair the two investors up, charge a nice fee for the service (the bid-ask spread), and everyone sings Kumbaya. That's client-driven market-making.

Client trading in fixed-income markets is going berserk right now. Why? The most logical explanation is that retail investors ditched stock funds after it poured red in 2008 and have been plowing money into bond funds ever since, perhaps thinking they're safer than stocks (note: They're not). One way to visualize this is by looking at stock mutual fund flows versus bond mutual fund flows over the past three years:

Year

Equity Fund Flows

Bond Fund Flows

2007

$91.3 billion

$108.5 billion

2008

($233.8 billion)

$27.1 billion

2009

($9.3 billion)

$376.3 billion

Source: Investment Company Institute.

In 2008, nearly a quarter-trillion dollars was yanked out of stock funds. And where did it all end up, and then some? Bond funds. That's been a boon to the fixed-income market. The more money sloshing around bond funds, the more bond fund managers need to buy and sell fixed-income products. And the more they're buying and selling, the more Wall Street banks are skimming off the top.

The other fixed-income trading windfall comes care of the Federal Reserve. Monetary policy is the office name here. "Mugging" is a more apt word that some have used to describe it. And while it's obviously perfectly legal, this is where so much banking outrage stems from.

Besides acting as a broker for client trading, most investment banks also engage in proprietary trading, which is making investments with their own money. And, man, do they have it good right now.

To help soften the blow of the financial crisis, the Federal Reserve has rammed short-term interest rates to essentially zero, begging banks to take its money.

Even in cases where banks aren't borrowing directly from the Fed, all classes of short-term bank borrowings have become nearly free sources of money. JPMorgan Chase was actually able to achieve a negative borrowing cost on some of its funds last quarter, literally getting paid to borrow money (and proving wrong those who say banks are borrowing for free).

That's made financing proprietary trades a giant joke. One example Matt Koppenheffer and I sarcastically used is a bank that borrows from the Fed at 0%, lend the money back to the U.S. Treasury at 3%-4%, and looks like a champion. Although we were being obnoxious with our example, this strategy is entirely real, and bankers are making awesome sums of money doing it. With the so-called "spread" between short- and long-term interest rates so high, proprietary fixed-income divisions have turned into money assembly lines.

Proceed with caution
While all this has spawned big profits (and the obligatory bonuses, of course), you have to keep it all in perspective. Not unlike the profits banks made from subprime a few years back, the questions you have to ask are: One, are these profits sustainable? And two, what happens when the music stops -- in this case, the return of higher interest rates? When you realize how reliant banks are on this one division, and then you come to terms with how unsustainable this division's profits are, the long-term prosperity of banks might not be quite as good as it looks.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 26, 2010, at 5:31 PM, fsx101 wrote:

    Why own the banks?

    Because AS (not when) the economy improves, their loan losses will reduce, charge off's will go down, and their earnings from true profits will go thru the roof.

    If their credit card delinquanncies drop to half of what they have been over the past year, the profits the banks will earn on their credit card operations will be fanastic again.

    The "Fed Spread" will go down, but their real earnings (ie, from customers paying interest on loans) will go UP dramatically (especially since they are not really extending much new credit, AND have already charged off much of their old/bad credit).

  • Report this Comment On April 26, 2010, at 11:56 PM, jayde24k wrote:

    Citibank is getting almost free money from the Fed and charging credit card customers like me, with many years of history and having never a missed payment, we are paying 18% or more on our balances. When does it become usury, or is that no longer part of the vocabulary?

    That for me would be the next crunch, if too many of us are pushed over the financial edge by companies we bailed out with our tax dollars.

  • Report this Comment On April 27, 2010, at 1:11 AM, vikas4 wrote:

    Fixed income - a big game, then what about commodities. It's not a secret any more that these guys with nominal characteristics of a banker and real intent of a super speculator have been cornering a big chunk of the commodities market. No wonder the assertive prophecies of burgeoning prices are eventually preparing for another blow to the real economy.

    Are there any regulators ?

    A banker, commodity trader, life ruiner, economic intimidator or what other name?

    Is there any collusion between the so called regulators and the wall street ?

  • Report this Comment On April 27, 2010, at 12:42 PM, ET69 wrote:

    To jayde24k,

    The answer to your question when did it become usury? Since banks were invented.:) They are just better at it than we are:) !

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