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Analysis: Bernanke's shrinking gift to Wall Street

By Lauren Tara LaCapra

NEW YORK (Reuters) - Wall Street could make $100 million from the Federal Reserve's next bond market maneuver, but that is considerably less than the gains from prior Fed actions.

Because the central bank is not contemplating steps that would increase the money supply, the benefit to investment banks like Goldman Sachs Group Inc, Morgan Stanley and JPMorgan Chase & Co will likely be more muted.

The Fed is considering intervening in the bond market to lower long-term interest rates in a move known as "Operation Twist." According to Rick Spear, who advises Wall Street banks on strategy at consulting firm Novantas, the effort could boost Wall Street trading revenue by $100 million through the Fed's direct purchases, as well as a "ripple effect" from other bond investors' activity.

That is piddling compared with the $23 billion of quarterly trading revenue that global banks averaged from 2000 through 2010, according to Oppenheimer Research, and compared with the $1 billion of extra revenue that Spear estimates Wall Street received from the second round of quantitative easing.

For the first two rounds of quantitative easing, the Fed was expanding the money supply by buying billions of dollars of bonds. The purchases translated to new money sloshing around the bond markets, which supported overall trading activity beyond the Fed's purchases.

Both rounds of quantitative easing coincided with relatively strong trading profit for Wall Street, with the biggest benefit coming from the first round, when the Fed was buying a wider array of products.

For Operation Twist, the Fed would be selling shorter-term Treasury notes on its books and using the proceeds to buy longer-term debt, which would decrease long-term yields. Cheaper long-term borrowing rates could potentially spur more borrowing in the economy.

But without new money, the benefit to banks could be limited to profits from trading with the Fed, traders said. Given that buying and selling Treasuries is a low-margin business, even big trades from the U.S. central bank would not help much.

"No one's upset with the short-term impact because it's giving some stimulus to trading activity," Spear said. "But banks don't make that much money from Treasury bond trading."

The Fed tried Operation Twist in the 1960s -- the name refers to twisting the relationship between short- and long-term rates, and to the dance craze of the era. Economists debate how much the original effort helped the economy, with many experts saying there was little boon at all.

Unpacking the final impact on banks for any Operation Twist is difficult, because there are so many moving parts.

Lower long-term yields could cut into banks' future interest income, which is already under pressure.

But lower long-term yields would also lift bond values, resulting in paper gains in trading portfolios for investment banking businesses. Given that many traders have been positioning for Operation Twist in recent weeks, gains on portfolios could be experienced in the third quarter.

If Operation Twist proved successful, some say Wall Street could benefit greatly: more loans, more deals, more securitization, more risk appetite among clients.

But that's a big "if."

"Stimulus is needed from both the fiscal and monetary side," said Terry Belton, global head of fixed income strategy at JPMorgan Chase. "The tools the Fed has available are limited. I think it's one of the better tools they have available at this point, but the effect will be small."

(Reporting by Lauren Tara LaCapra, additional reporting by Mike Tarsala, Editing by Dan Wilchins and Gerald E. McCormick)

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