A tenant gives the landlord a $500 rent check on Friday afternoon, then hustles to the bank to "cover" the check, knowing it won't be cashed until Monday.
A big company pays all its East Coast bills from a small bank in a remote county in Oregon and all its West Coast bills from an isolated bank in Maine. It takes three days from the time the creditor deposits a check until it is presented for payment at the big company's bank.
Both the tenant and the company are taking advantage of float time -- the period that elapses, be it hours or weeks, from the moment a check is written until it is paid by the check writer's bank. Until the check is "presented" for payment, the check writer continues to have use of the funds that will cover the check.
The tenant may be trying merely to juggle the landlord's demand for the rent and the receipt of a paycheck. But a company may be able to make big money if it can delay payment for a day or two.
If a company can hold on to $10 million for an extra day, every day for a year, it could realize an extra $850,000 in income by investing the funds overnight at 8.5 percent, roughly today's rate.
In 1981, when interest rates were as high as 18 percent, the company would earn $1.8 million a year.
So long as companies can make money on the float, they will be as aggressive as possible in taking steps to delay payments to creditors -- or in speeding up payments from customers and debtors.
Banks, similarly, try to collect a deposited check as fast as possible. Until a bank collects the check, the deposit is not available to the bank to be loaned out or otherwise invested. While that check is in the process of collection, the depositor theoretically does not have use of the funds unless the bank permits it.
In reality, until recent computer developments, most banks found it difficult to differentiate between total deposits and those deposits that actually have been collected. They usually knew what a customer had deposited, but they did not know how much of that deposit was an "uncollected balance" that was still floating in the check-processing system.
E. F. Hutton Inc., the big brokerage firm, pleaded guilty 10 days ago to exploiting that gap in many of its banks' knowledge. It made big withdrawals from many of those banks and covered the withdrawals by depositing E. F. Hutton checks drawn on company accounts in other cities. Until those E. F. Hutton checks cleared, Hutton had use of the funds in both accounts. In effect, the banks gave E. F. Hutton interest-free loans. Hutton said the practice began in July 1980 and ended Feb. 28, 1982.
Hutton pleaded guilty to 2,000 counts of mail fraud and wire fraud, paid a $2 million fine and agreed to make restitution to its banks. Robert Ogren, chief of the criminal fraud division in the Justice Department, said banks were cheated out of tens of millions of dollars of income.
Albert Murray Jr., the assistant U.S. prosecutor in Scranton who shepherded the investigation, said other U.S. companies appear to be using techniques similar to those used by Hutton.
The existence of the float is a reality in a payments system that relies upon pieces of paper to move funds from one bank account to another. Electronic transfer of funds is far quicker and cheaper. But because companies can make money holding on to funds, they still prefer checks.
According to economists at Morgan Guaranty Trust Co., a study that covered the cost of government electronic payments and check payments in 1981 showed that, when the float was ignored, costs were about 27 cents per electronic payment and 40 cents per check. But when the lost interest on the float was calculated, the cost of electronic payment rose to 97 cents an item. The differential would be narrower today, but still substantial.
Moving those pieces of paper around is a big, complicated business that involves many thousands of people and fleets of planes and ground couriers to transport checks from point of deposit to point of collection.
The collection process involves local clearinghouses -- where banks in the same area get together and exchange checks -- regional clearing and national clearing. The Federal Reserve System operates a big check-clearing operation. Big banks collect checks for smaller correspondent banks, then exchange checks among themselves or use the Federal Reserve.
When a check is deposited in an account, the bank must physically take that check to the bank on which it is drawn and receive credit from the paying bank.
Checks written on Riggs National Bank and deposited in American Security Bank are exchanged the next morning at the local check clearinghouse. Say Riggs has $10 million of checks written on ASB and ASB has $11 million of Riggs checks. The two banks will net out the difference and Riggs will transfer $1 million to American Security.
But a check written on an account at Bank of America and deposited in American Security must go clear across the country to San Francisco. First, ASB will encode the amount of the check in magnetic ink on the bottom. It then will put it together with all other Bank of America checks in a cash letter -- a listing of all B of A checks and the total amount B of A owes American Security.
American Security then will bring the cash letter to the Federal Reserve processing center, which will give American Security provisional credit in the account the bank maintains with the Richmond Federal Reserve. The Fed then will fly the check -- along with tens of thousands of other area checks drawn on California banks -- to San Francisco.
The San Francisco Fed then will present the check to Bank of America and debit Bank of America's account.