Bank Bonuses $33 Billion

Nine banks that received government aid money paid out bonuses of nearly $33 billion last year -- including more than $1 million apiece to nearly 5,000 employees -- despite huge losses that plunged the U.S. into economic turmoil.

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Top employees at nine big U.S. banks that received government aid shared a bonus pool of $32.6 billion. A breakdown of those receiving more than $1 million each.

The data, released Thursday by New York Attorney General Andrew Cuomo, provide a rare window into the pay culture of Wall Street, where top employees typically make 90% or more of their compensation in year-end bonuses.

The $32.6 billion in bonuses is one-third larger than California's budget deficit. Six of the nine banks paid out more in bonuses than they received in profit. One in every 270 employees at the banks received more than $1 million.

Overall compensation and benefits at the nine banks fell 11%, to $133.5 billion in 2008 from $149.3 billion in 2007, the Cuomo report said. But with net revenues falling, the percentage of the firms' revenues dedicated to compensation rose to 45% last year from 41% in 2007.

The report reignites long-simmering anger, on Capitol Hill and beyond, over big Wall Street payouts. The nine firms in the report had combined 2008 losses of nearly $100 billion. That helped push the financial system to the brink, leading the government to inject $175 billion into the firms through its Troubled Asset Relief Program.

The chairman of the U.S. House investigative panel, New York Democrat Edolphus Towns, called the pay figures "shocking and appalling" and announced a hearing into compensation practices at banks.

The White House was more muted. "The president continues to believe that the American people don't begrudge people making money for what they do as long as...we're not basically incentivizing wild risk-taking that somebody else picks up the tab for," said White House Spokesman Robert Gibbs.

More

• Read the full report from the New York Attorney General's office.
• Real Time Econ: Back to the Good Times
• Financial News: Bloggers' reactions

Deal Journal

• What Are Your Chances of Being a Millionaire?
• Bonus Breakdown From Cuomo's Report

Those on Wall Street argue they have to pay to keep talent. Often, bankers say, only a small group is responsible for losses and it is not fair to punish employees in other areas of the business. They say the compensation system will be difficult to change.

"These pay packages are pretty outrageous," said Michael Baldock, a partner at Stamford, Conn.-based boutique bank Ondra LLP, who has worked at a number of big investment banks. "But if you generate $10 million in revenue a year, another firm will always want that revenue and be willing to pay for it."

In releasing the report now, New York Attorney General Cuomo is vaulting ahead of federal efforts to assess and curb excessive pay. The office has been among the first to investigate and bring charges on several Wall Street abuses this decade.

The House of Representatives is preparing to vote as early as this week on a bill that would give shareholders nonbinding say on pay packages and give regulators more tools to prohibit risky pay practices at banks and other regulated financial firms. The Senate isn't expected to vote on the legislation until the fall.

The Obama administration, meanwhile, is preparing to vet pay at firms receiving "exceptional assistance" from the government. Institutions have until Aug. 13 to submit proposed compensation details for the 100 highest-paid employees at each. The Treasury Department's pay czar, Kenneth Feinberg, could push banks to renegotiate deals he sees as rewarding risky behavior or that are out of line with compensation at similar institutions.

Andrew Williams, a Treasury spokesman, said Mr. Cuomo's report "focuses on strengthening the link between pay and performance -- a goal that we share."

Andrew Cuomo

Mr. Cuomo said Thursday he hopes his report will prompt the financial firms themselves to significantly overhaul their pay system to reward long-term performance rather than short-term gains. His report didn't release names of individual bonus recipients because of privacy concerns.

"The banks say they pay for performance," Mr. Cuomo said of the data. "Yet in 2008 there was no performance and they still continued to pay out huge sums of money."

Wall Street has shown little sign of slowing down the pay train this year. Goldman Sachs Group Inc. and Morgan Stanley recently disclosed that they have set aside $11 billion and $6 billion in compensation and benefits, respectively, for their employees so far this year. Goldman's second quarter was among its best ever. Morgan Stanley lost money for its third straight quarter.

Goldman and Morgan Stanley declined to comment on the report.

Meanwhile, some big banks that received government bailouts, including Citigroup Inc. and Bank of America Corp., are offering handsome pay packages to lure stars. Citigroup -- which received about 25% of the aid going to the nine banks -- has the No. 1 pay recipient. Andrew Hall, who heads Citigroup's energy-trading unit Phibro LLC, received $98.9 million in 2008, according to a government official. Citigroup CEO Vikram Pandit, by comparison, received more than $38 million last year.

An early test for Mr. Feinberg will be the pay of Mr. Hall, whose profit-sharing contract with the bank could again entitle him to as much as $100 million, say people familiar with the matter.

James Forese, Citigroup co-head of global markets, cited Phibro's "consistent track record of profitability" and said its contracts directly align compensation with performance. "That said, we are sensitive to the need for a full review of compensation practices in our industry," he said. "We are evaluating the best way forward for stakeholders."

The group of nine's No. 2 bonus for last year, according to a government official, was the $39.4 million that went to Bank of America's Thomas Montag. In 2008, Mr. Montag was sales and trading chief at Merrill Lynch, which got crushed by billions of dollars in mortgage-related losses and was sold to Bank of America. Mr. Montag's pay package included stock grants, which since have fallen in value.

Bank of America said bonuses for Merrill Lynch were shared among 30,000 employees and Bank of America's figures cover more than 200,000 employees.

The study found that pay at the banks remained near previous levels despite revenue declines. Merrill's net revenue fell by $23 billion in 2008, leading to a huge net loss. The firm's pay and benefits dropped by $1.1 billion, or 7%, according to the study. At Citigroup, revenue fell by $28 billion, or 34%. Pay and benefits dropped $2 billion, or 6%.

Similarly, at Goldman and J.P. Morgan Chase & Co., pay fell less sharply than revenue in 2008. Both firms have paid back the government loans they received under TARP. J.P. Morgan declined to comment on the report.

Goldman, Morgan Stanley and Merrill, Wall Street's three largest securities firms in 2008, paid nearly $13 billion in bonuses last year, the report says. That was roughly one-third of their total pay and benefits of $38 billion, according to securities filings.

J.P. Morgan topped other banks in the number of employees receiving $1 million or more -- 1,626 out of its 224,961 employees. This figure includes bonus, salary and options; the numbers of other banks in the study includes bonuses only.

J.P. Morgan's top earner collected $29 million, more than James Dimon, the firm's chief executive, who got $19.7 million in total compensation last year.

Goldman paid the most per employee, about $160,000 each for more than 30,067 staffers. Some 212 Goldman bankers made $3 million or more. Goldman, which weathered the credit crisis better than most rivals and made $2.3 billion in 2008, produced the most revenue per employee, $77,228.

Goldman has said that no partner got a bonus of more than $222,500 in cash. The rest was paid in deferred stock, with an extra year of service required for any of it to vest.

Morgan Stanley had 428 employees who received bonuses of $1 million or more. In addition, 10 people received bonuses of $10 million or more, for a combined $146.8 million.

Wells Fargo & Co., Bank of New York Mellon Corp. and State Street Corp. round out the nine banks. Each declined to comment.

—Aaron Lucchetti, Daniel Fitzpatrick and Robin Sidel contributed to this article.

Write to Susanne Craig at susanne.craig@wsj.com and Deborah Solomon at deborah.solomon@wsj.com

Soaking the poor

Ever use your debit card and overdraw your checking account, only to later discover that the bank lent you the money -- at a fee -- to cover the overdraft?

Do the math. You may find that you paid an effective 3,000 percent annual interest rate on a courtesy loan you never asked for.

Electronic Loan Sharking

Consumer advocates have been calling on financial institutions to address abusive overdraft practices for several years, and now Congress is poised to act.

"I don't know what loan sharks are charging these days, but these rates are probably a bit higher," says Eric Halperin, director of the Washington office of the Center for Responsible Lending (CRL). "They're more expensive than any other financial product out there."

In the old days, banks would deny a check payment if you didn't have adequate funds in your account, and charge a bounced-check fee. The only way to avoid this (both then and now) was to have a backup -- a link to a savings account or line of credit. If overdrafts became too frequent, the bank would close your account.

Fee Overload

Today, debit and other electronic transactions are the dominant form of payment. Rather than deny payment, most banks automatically cover your small-dollar overdraft and slap you with a fee averaging $34 on every subsequent transaction until your account is back in the black.

A CRL study released this month found consumers pay $17.5 billion in fees on abusive overdraft loans. The average overdraft is just $27, and is typically repaid within five days.

"In 2004, 80 percent of banks routinely declined overdrafts," says Halperin. "Today, 14 of the 15 largest banks routinely cover overdrafts. It indicates a dramatic shift in the marketplace." The Federal Reserve allows banks to enroll consumers in overdraft protection programs without their written consent.

Shady Practices

Moreover, banks can legally manipulate the order in which they pay checks and debits to maximize fees. Consider this example: Bob thinks he has $1,300 in his checking account, but he only has $1,150. He conducts six debit transactions totaling $180, and then pays his rent, for $1,100. He's overdrawn the account by $130.

Bob's transactions arrive in one batch at the bank. Instead of paying the six transactions and charging a single overdraft fee on the rent check, the bank pays the rent check first, followed by one transaction for $50. It then provides overdraft loans for the other five payments, so Bob incurs five separate fees of $34 each -- or $170. (Banks reserve the right to pay checks in any order; see, for example, the policy of U.S. Bank.)

Two weeks later, Bob deposits his paycheck, and the bank gets its money back. Bottom line: When Bob pays $170 for a two-week loan of $130, the annual percentage rate comes out to 3,400 percent. (See my blog for details on this calculation.) But the Federal Reserve has ruled that overdraft fees are not considered finance charges that have to be disclosed, a spokesperson said.

Preying on the Most Vulnerable

Overdraft loan abuses fall mostly on the backs of middle- and lower-income consumers with little financial education, like Paddy Page, an Idaho mother of four. She receives no child support from the abusive husband she left six years ago, who's now in prison.

Page, who dropped out of high school but eventually earned her GED, works full time as a bill collector for Citibank, making $12 an hour. With no family nearby, she was on her own after her divorce.

"Once you get caught in the cycle, it's hard to get out of it," Page says, adding that most of her overdrafts were for groceries and medical bills for her kids. She racked up nearly $500 in overdraft fees last year at Washington Mutual Bank -- $243 of it over a two-day period in August, for nine overdrawn transactions.

Sleepless Nights, Tipped Scales

Like many consumers, Page didn't maintain her checkbook register, relying on her online account balance -- which didn't factor in outstanding paper checks. And because Page chose Washington Mutual's "free" checking account, she wasn't eligible to open a cheaper line of credit.

"I couldn't make it. There were times when I had no money and no groceries," she recalls. "I'd go to the grocery store and think, 'What else can I do?' I'd write a check, the bank would cover it, and on my next paycheck I'd be fighting to get back up to zero in my account. I couldn't sleep at night; I was about to lose my home."

Clearly, the consumer who spends more than he or she has is at fault. But the scales may be tipped against them: The Check Clearing for the 21st Century Act, approved in 2004, allows banks to clear checks they receive more quickly than in the past. But the act doesn't require financial institutions to credit deposits any faster.

Page, for instance, says she would sometimes make a deposit and get hit with an overdraft fee because the credit didn't clear as quickly as she expected.

Without Warning

Consumer advocates would like to see banks provide a warning to consumers if a transaction would overdraw their account. Similar technology already exists: When you use another bank's ATM, you sometimes receive a warning that you'll pay a $1 or $2 fee. You can choose whether to pay the fee or cancel the transaction.

A survey conducted by CRL earlier this year found that three-quarters of consumers wanted to be warned if they were on the verge of withdrawing more than they had in their account.

But the American Bankers Association (ABA) says it would be unfeasible to apply the technology this way; it would lengthen transaction times and raise the costs to merchants and consumers. "Consumers are in control of their finances and can avoid overdraft fees," said Nessa Feddis, ABA senior federal counsel, in a Congressional hearing earlier this month.

A Happy Ending

Happily, Page got back in control of her finances with the help of a fellow church member who's a financial executive.

They worked together to create a budget; get on time with her bills; learn to steer clear of high-fee payday loans and check-cashing stores; and pay off her credit cards.

Page's oldest two children are now in college. "I tell my kids all the time that education will set you free," she says. "You don't want to be bouncing checks and always scrounging money just to have groceries. It's ridiculous."

Help on the Horizon

Representatives Carolyn Maloney (D-N.Y.), Barney Frank (D-Mass.), and Julia Carson (D-Ind.) are sponsoring legislation (HR 946, or the Consumer Overdraft Protection Fair Practices Act) to protect consumers from abusive overdraft policies. The act contains four common-sense provisions to address some of the industry's sneakier tactics. It would:

• Require written consent from the consumer before enrollment in an overdraft loan program.

• Require financial institutions to warn the customer when an ATM withdrawal will trigger a fee -- and allow the customer to cancel the transaction at that time.

• Prohibit financial institutions from manipulating the order of check clearing or delaying the posting of deposits to increase customers' overdraft loan fees.

• Amend the Truth in Lending Act to clarify that overdraft fees are finance charges, so that annual interest rates are reported. This would allow consumers to compare overdraft loans with other credit options -- such as lines of credit, which typically offer annual interest rates of less than 20 percent.

Act Now

In her prepared remarks, the ABA's Feddis told the Congressional hearing that forcing financial institutions to report an annual percentage rate would confuse customers: "In these cases, the fee is fixed, the overdraft often small, and the term of repayment short. It is easy to see how triple digit APRs would result ... In the overdraft-fee context, consumers understand a dollar amount far better than an inflated and meaningless APR."

I think consumers are brighter than that: Given a chance to consider the APR on overdraft loans, they'd understand that their bank has been taking them to the cleaners.

Click here to email your support for the Consumer Overdraft Protection Fair Practices Act bill.

Bank Bonuses

Bank Pay Outrageous, But Is That Recovery?

by Rick Ackerman on August 3, 2009 12:01 am GMT · 12 comments

Assuming Americans still have the capacity for outrage, they should be rioting in the streets following last week’s reports that nine big banks paid out $33 billion in bonuses in 2008. The Wall Street Journal put this travesty in perspective, noting that the bonuses were a third larger than California’s budget deficit. “Six of the nine banks paid out more in bonuses than they received in profit,” the Journal reported, and “one in every 270 employees at the banks - [a total of 5,000 employees] –received more than $1 million.”

Compare these princely sums to the relatively paltry numbers associated with the government’s “cash for clunkers” program, which provides a U.S. voucher of up to $4,500 for motorists trading old gas guzzlers for new vehicles. Cash-for-clunkers ate through $1 billion of funding last week in its first four days, prompting Capitol Hill to approve yet another $2 billion, presumably before things turned ugly on the dealers’ lots. Talk about bread and circuses! If the cash-for-clunkers giveaway enjoyed the kind of backing the banks received via TARP, thousands of Americans who don’t have two nickels to rub together would be driving Bentleys, Ferraris and Lamborghinis.

No Shame

Lest you think the banks are embarrassed by it all, it has been reported that Goldman Sachs, for one, is on course to pay $20 billion in bonuses in 2009 — an average of $700,000 for each and every employee. Over at Morgan Stanley, bonuses are up 30%, to an average $340,000; and at J.P. Morgan, the incentive pool for the first quarter alone has swelled by 175% to $3.3 billion.

These numbers came to light in a report issued by New York Attorney General Andrew Cuomo. Shortly thereafter, New York Rep. Edolphus Towers, chairman of the U.S. House investigative panel, pronounced the news “shocking and appalling.” He promised hearings into the matter, but we’re not holding our breath. At other times in history there would be scaffolds going up in the town centers, and kangaroo courts convened at midnight to condemn the offenders. Instead, we are being asked to believe the brazen falsehood that the banks are leading us out of recession. In fact, as a report issued recently by Matterhorn Management makes clear, “none of the problems in the banking system have been resolved. The system still has a leverage of 25-50 times, it is still full of toxic debt and derivatives, loan books are deteriorating daily, it still has worthless paper assets valued at fantasy prices and most banks are run by the same bankers who created the problems in the first place. For a typical bank, a 4% drop in asset value wipes out the equity. This is what we call a recipe for disaster.”

Fed Buys It's Own Debt and tries to cover it up

BLATANT Monetization Uncovered

Remember the Dallas Fed's Fisher saying that "The Fed will not become the handmaiden of Treasury"?

He was lying (The Fed already has), and now there is proof.

Mad props to both Zerohedge and Chris Martenson for noticing this; I missed the facts buried in the CUSIP list.

The upshot: The Fed bought nearly half of LAST WEEK'S 7 year Treasury Issuance TODAY.

Huh? Remember, after the 5 year auction that went badly (and which I wrote about) the 7yr auction went "well." Rick Santelli (and a lot of other people) agreed - demand was strong. That made no sense to me at the time, coming one day after a near-failure in the 5 year.

Well now we know what happened: The Fed pretty clearly pre-arranged, either explicitly or by "suggestion", that the Primary Dealers take up the auction with the promise that The Fed would immediately monetize half what the Primary Dealer's took!

Folks, this is beyond bad - it is pernicious and outrageous conduct by The Federal Reserve in conspiracy with the Primary Dealers, both of which are now desperately trying to prop up the US Government Bond Market through subterfuge rather than just buying up the bond issue from Treasury when originally put to the market!

If you think the economy and credit markets are "on the mend" why would The Fed do something like this? It would not be necessary unless The Fed was told (by those very same Primary Dealers) that they were going to be unable or unwilling to take down any more Treasury Debt.

Folks, let me be clear: The United States HAS OFFICIALLY HIT THE TREASURY DEBT WALL and The Fed and Treasury are engaged in subterfuge and conspiracy in an attempt to hide this from the market.

There is no other explanation for what just happened.

None.

This is likely what the market figured out:

When it sinks in to the market's consciousness - we had two failed Treasury Auctions last week, both 5 and 7 year, yet we intend to try to borrow ANOTHER $400 billion next quarter and nearly $100 billion this coming week - the consequences could be extremely severe.

Hunger hits Detroit's middle class

Food has long been an issue in this city without a major supermarket. Now demand for assistance is rising, affecting a whole new set of people.

By Steve Hargreaves, CNNMoney.com staff writer

Last Updated: August 7, 2009: 12:38 PM ET

DETROIT (CNNMoney.com) -- On a side street in an old industrial neighborhood, a delivery man stacks a dolly of goods outside a store. Ten feet away stands another man clad in military fatigues, combat boots and what appears to be a flak jacket. He looks straight out of Baghdad. But this isn't Iraq. It's southeast Detroit, and he's there to guard the groceries.

"No pictures, put the camera down," he yells. My companion and I, on a tour of how people in this city are using urban farms to grow their own food, speed off.

In this recession-racked town, the lack of food is a serious problem. It's a theme that comes up again and again in conversations in Detroit. There isn't a single major chain supermarket in the city, forcing residents to buy food from corner stores. Often less healthy and more expensive food.

As the area's economy worsens --unemployment was over 16% in July -- food stamp applications and pantry visits have surged.

Detroiters have responded to this crisis. Huge amounts of vacant land has led to a resurgence in urban farming. Volunteers at local food pantries have also increased.

But the food crunch is intensifying, and spreading to people not used to dealing with hunger. As middle class workers lose their jobs, the same folks that used to donate to soup kitchens and pantries have become their fastest growing set of recipients.

"We've seen about a third more people than before," said Jean Hagopian, a volunteer at the New Life food pantry, part of the New Life Assembly of God church in Roseville, a suburb some 20 miles northeast of Detroit. Hagopian said many of the new people seeking assistance are men, former breadwinners now in desperate need of a food basket.

Hagopian is an 83-year old retired school teacher. She works at the pantry four days a week, spending two of those days driving her own minivan around town collecting food from local distributors.

The pantry, housed in the church basement, gives away boxes of food that might feed a family of four for a week. It includes dry and packaged goods like cereals and pasta, peanut butter, canned fruits and vegetables, 7 or 8 pounds of frozen meat (usually chicken or hot dogs), and eight pan pizzas donated from a local Pizza Hut. Most of the other food is purchased from a distributor or donated by the county food program. Last month they gave out 519 boxes.

Hagopian hopes the demand for food doesn't get much worse.

"I hope we're at the top of it because we'll run out of food, and then we'll have to go out and find some more," she said.

She should brace for the worst. Across metro Detroit, social service agencies are reporting a huge spike in demand for food assistance.

Gleaners, an agency that distributes excess food donated from food processors, says their distribution is up 18% from last year. Michigan Department of Human Services, which handles federal food assistance like food stamps, WIC checks and such, has seen a 14% spike in applications since October. Calls to the United Way's help line have tripled in the last year.

"Given the resources, we could double our numbers," said Frank Kubik, food program manager for Focus:Hope, a Detroit aid organization that fed 41,000 mostly elderly people last year. Kubik said his program is restricted by charter and budget from serving more than its current number of clients. But if that were changed, he could certainly serve up more meals.

"There's no doubt about it, there's just so many out there that are really struggling right now," he said.

The changing face of hunger

There have been plenty of people struggling in Detroit for a long time. What makes this recession different is the type of people coming in. It's no longer just the homeless, or the really poor.

Now it's middle class folks who lost their $60,000-a-year auto job, or home owners who got caught on the wrong side of the real estate bubble.

Many of these people have never navigated the public assistance bureaucracy before, and that makes getting aid to them a challenge.

"They have no idea where the DHS office is," said DeWayne Wells, president of Gleaners, the food distributor.

To assist these newly hungry, Wells pointed to the United Way's 211 program, where people can call the hotline and speak to an operator that guides them through a wide range of available social services.

The Michigan Department of Human Services is going digital, rolling out a program where people can apply for food stamps via the Web.

That may help ease another challenge in getting aid to the middle class: pride. Many people feel so bad about having to ask for help that they just don't, or they have issues with it once they do.

"They'll say things like 'I've never had to do this before' and they feel a little uncomfortable," said Hagopian, the retired school teacher. But she says times have changed, the good union jobs are disappearing and it's harder and harder to find work.

"I just tell them society is not what it used to be," she said.

Detroit responds

Actually running out of food doesn't seem to be a problem, so far. In fact, because more people are being affected the response seems to be greater.

"A few years ago it was someone you saw a profile of on TV," said Wells. "Now it's your brother in-law, or the people your kid plays soccer with."

Wells said volunteers are up at Gleaners, as is general community awareness.

The Feds have helped too. Food stamp allowances were increased 14% nationwide under the stimulus plan.

Detroiters are also helping themselves in smaller ways. Thanks to the dearth of big supermarkets in Detroit proper - a phenomenon largely attributed to lack of people - and plenty of vacant land, community gardening has caught on big.

It's not so much that these gardens are going to feed the city, although they certainly help. It's more that they can be used to teach people, especially children, the value of eating right.

"I use vegetables every day," said one child at an after school gardening program run by Earthworks Urban Farm, near the heart of the city. "Last night, an onion I picked from here, I had in my potatoes."

Hearing that is good news to people like Dan Carmody, president of Eastern Market Corp., a century-old public market selling fresh produce and other foodstuffs near downtown Detroit.

Carmody is part of a group of people trying to bring healthy food to town. The efforts include setting up mobile produce stands around the city, working with convenience store owns to stock better produce, and trying to set up a program that allows food stamp recipients to spend twice as much money if they buy from a local farmer.

He says the food situation in Detroit is particularly depressing because the surrounding areas are chock full with some of the best eats around: Michigan grows some of the most varied crops in the nation, everything from apples and cantaloupes to peaches and watermelon. Windsor, just across the bridge, is the hydroponics capital of Canada. Artisan Amish farms are also close by in Ohio and Pennsylvania.

Getting this food to Detroit, and getting Detroiters to buy it is the challenge. That's where the urban farms come in.

"Once kids start seeing where their food comes from," he said, "it changes the whole approach to how they eat."

California putting the screws to small business

SAN FRANCISCO (CN) - Small businesses that received $682 million in IOUs from the state say California expects them to pay taxes on the worthless scraps of paper, but refuses to accept its own IOUs to pay debts or taxes. The vendors' federal class action claims the state is trying to balance its budget on their backs.
Lead plaintiff Nancy Baird filled her contract with California to provide embroidered polo shirts to a youth camp run by the National Guard, but never was paid the $27,000 she was owed. She says California "paid" her with an IOU that two banks refused to accept - yet she had to pay California sales tax on the so-called "sale" of the uniforms.
The class consists mostly of small business owners, many of whom rely on income from government contracts to keep afloat. They say California has used them as "suckers" as it looks for a way to bankroll its operations while avoiding its own financial obligations.
"Instead of seeking funds through proper channels, the State has created a nightmare," the class says. "Many of these businesses will not survive if they are required to wait until October 2009 to have these forced IOUs redeemed by the State."
The class claims the state is violating the Fifth and Fourteenth Amendments. It demands that California be ordered to honor its own IOUs, plus interest. They are represented by William Audet.

Traders Profit With Computers Set at High Speed

July 24, 2009, 4:10 am

It is the hot new thing on Wall Street, a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices. It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets, writes Charles Duhigg in The New York Times.

Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.

These systems are so fast they can outsmart or outrun other investors, humans and computers alike. And after growing in the shadows for years, they are generating lots of talk.

Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer.

And when a former Goldman Sachs programmer was accused this month of stealing secret computer codes — software that a federal prosecutor said could “manipulate markets in unfair ways” — it only added to the mystery. Goldman acknowledges that it profits from high-frequency trading, but disputes that it has an unfair advantage.

Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.

“This is where all the money is getting made,” William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund, told The Times. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”

For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.

But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.

“It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange. “Markets need liquidity, and high-frequency traders provide opportunities for other investors to buy and sell.”

The rise of high-frequency trading helps explain why activity on the nation’s stock exchanges has exploded. Average daily volume has soared by 164 percent since 2005, according to data from NYSE. Although precise figures are elusive, stock exchanges say that a handful of high-frequency traders now account for a more than half of all trades. To understand this high-speed world, consider what happened when slow-moving traders went up against high-frequency robots earlier this month, and ended up handing spoils to lightning-fast computers.

It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.

Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates.

“You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient,” said Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques. “But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.