Is Wall Street front - running the Fed?

How does Wall Street make money? Even as financial reports link different kinds of trading and big profit numbers, they don't help the public understand exactly how the traders earned those out-sized profits. But it's really not that hard to understand, at least in part. One source may be a little practice called "front-running" and it takes many forms.

In a nutshell, Wall Street sometimes knows what its customers are going to do and it profits by getting there before its customers. If you knew, for example, that a customer was going to buy $40 billion worth of stock in, say, International Business Machines (IBM), you could just buy IBM shares for your own account and voila -- when that customer later makes that $40 billion purchase, the stock goes up and you take your profit. Of course, in its crudest forms, this is an illegal practice.

However, one way that appears perfectly legal is to use this kind of front-running on bonds -- specifically, those the Fed buys. The Financial Times interviewed a former Federal Reserve executive who said that the Fed broadcasts its trading plans beforehand. As a result, banks can buy up the securities the Fed intends to buy and sell them to the Fed at an inflated price. Barclays sends e-mail to clients with news on the Fed's balance sheet, detailing the share of the market in particular securities held by the Fed.

And it's not exactly a secret that the Fed is buying, for example, mortgage-backed securities (MBSs). The Fed has a nice description of this program on its website -- it intends to buy $1.25 trillion worth of so-called Agency MBSs by the end of 2009. Banks can profit quite simply by going out into the market ahead of the Fed and reselling the MBSs to the Fed at a profit.

It does not take a genius to make money doing this. In fact, it would be very simple to program a computer to get information about the Fed's intentions and then buy whatever securities the Fed had announced it was going to purchase and then resell them to the Fed at a profit.

Is this legal? Yes -- after all, the Fed's intentions are not inside information when it broadcasts them. Besides, insider trading rules don't apply to the bond market, which is several times bigger than the stock market which does have insider trading rules (but those don't apply to Congress). And the real reason it's so easy to make money doing this is that not everyone can raise the capital needed to do business with the Fed. You have to be too big to fail to profit from taxpayer money.

Does it sound like it should be illegal? Absolutely. But it doesn't look like there's any pressure to stop it. And the costs to society are likely to remain high because it means that we will use our taxpayer money to pay bonuses to the people who pick this easy money up off the ground.

Meanwhile, the Fed pays higher prices and thus raises the government's interest expense because it is overpaying for these securities. In theory, the Fed could buy securities directly and keep its intentions secret -- but that would cut Wall Street out of its easy money.

And we can't afford that, can we?

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. Follow petercohan on Twitter. He has no financial interest in the securities mentioned.

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