Stock Research – Wall Street Makes Fortune Sweeping Your Cash

Years ago, I was a limited partner at Bear Stearns and Company in New York City. Once a year, we would have a partner’s meeting, and I would attend as a matter of course. Now keep in mind that we were a trading firm, also a brokerage firm. Back then we didn’t do nearly the amount of investment banking that is done by some of the majors such as Goldman, Merrill, and Lehman Brothers at the time.

What was most interesting however is that we always referred to ourselves as “The Bank”. It’s a strange term when you consider that we were never licensed as a bank by the appropriate federal agencies. Nevertheless, on Wall Street when people were talking about their own specific firms, they always internally talked about “The Bank”.

The reason for this term is quite simple and appropriate. Years ago, if you wanted to know how much money a brokerage firm made all you had to do was calculate interest earned versus interest expense, and you basically had the bottom line, give or take a bit on a pretax basis. When I was s Senior Accountant with Arthur Andersen in the early 1970’s, this calculation was always appropriate, and we dominated banking and finance type companies at that time.

Recently after all these decades it looks like the same technique applies today that applied back then. Most individuals and institutions are still not making the interest they should be making, on the funds they have deposited with brokerage firms. They need to keep a better eye on their funds. The whole issue is the concept of IDLE CASH, and what is being done with it. Back in the late 70’s, Merrill Lynch led the industry with the development of what they called the CMA account which stood for Cash Management Account.

The objective was to go up against the banks both commercial, as well as savings and loan and fight for the cash. What the brokerage firms are doing now is sweeping your idle cash from your accounts on a daily basis and paying you interest on that dollar amount. What are the brokerage firms paying? The answer is probably as little as they possibly can. Recently I saw rates on the order of 1.5%.

What happens is that at the end of the day, the firm checks to see what idle cash is available in your account. It then sweeps the cash and pays you 1.5% on the balance or less. Meanwhile the firm acting like a bank will reinvest your cash over night in its own firm account at a much higher rate. Do these numbers amount to anything?

Would you believe that last year in 2006 Merrill Lynch must have made net, net $2 billion for its own account after paying out lesser amounts in interest to its customers on their idle cash balances? That’s right; they made $2 billion after expenses but before taxes. Is this any way to run a firm? You bet it is. The $2 billion was up from $1.3 billion two years before that. This mean’s the firm is getting better at sweeping the balances, and they are sweeping bigger balances.

Morgan Stanley started getting into the act last year, and Smith Barney which is owned by Citigroup got into the game late by starting up last September with the same technique. When Merrill was quizzed about the practice, they came back and said that the brokers at the firm are encouraged by the firm to discuss “higher-interest options” in order to “meet specific client demands”. Now I own a brokerage firm, and have been in the business for 30 plus years, my answer to that is “SURE”.

The master of this game is Charles Schwab, the discount brokerage house. They were using this technique years before anyone else. Merrill apparently took it from them. Today if you study Schwab’s financials closely, there is no question that they make more money from sweeping the idle cash from their client’s accounts, plus margin interest than they do from brokerage commissions.

Brokerage firms also pay different interest rates on these idle cash balances depending upon the actual balance. The small guy gets hurt, as he always does by having less money to deal with. Balances below a $100,000 usually get the lowest rate which is probably about 1.25% at the moment. The big boys who have over a $1,000,000 sitting in the account can easily negotiate a higher rate by simply picking up a telephone. What the brokerage firm counts on is not getting that phone call.

Since most people with brokerage accounts are always transacting business by buying and selling securities, they are not consciously aware of their idle cash balances all the time. They are thinking about gains and losses, not interest. This is a mistake, because if you are not watching your money, who’s watching it. The guy in charge of sweeping your account, is he watching it? You bet he is, but it’s not your interest he has at heart. His year end bonus is completely dependent upon how much he sweeps, and how little he has to pay you for your own money.

Forget about reading the small print in your agreements with the investment companies. They use language that requires a lawyer to interpret. That’s why the agreements are written by lawyers. The agreements will tell you that the accounts are “tiered”. This means the larger the balance, the more interest you will get. Now how are you supposed to know that?

Wachovia which owns the old Prudential broker network waits until the fourth paragraph of their customer agreement to tell you that Wachovia “may seek to pay as low a rate as possible.” This reminds me of the time that I was talking to a General Motors engineer about how much the jack cost in the trunk. His answer at the time was a”50 cents”. I said you got to be kidding, are you telling me that my life is dependent upon a 50 cent jack when I get a flat tire in the middle of a winter night. His answer was “Yes, 50 cents is what we pay.” As I walked away, he yelled, “Do you want to know why we only pay 50 cents for that jack.” I said sure, why? He said, “Because we can’t get one for a quarter.”

Be careful what you do with your cash, who’s calling the shots on it.

Goodbye and Good Luck