Why the Fed Let Banks Pay Billions to Shareholders
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By JESSE EISINGER
March 4, 2012

In early November 2010, as the Federal Reserve began to weigh whether the nation’s biggest financial firms were healthy enough to return money to their shareholders, a top regulator bluntly warned: Don’t let them.

“We remain concerned over their ability to withstand stress in an uncertain economic environment,” wrote Sheila Bair, the head of the Federal Deposit Insurance Corp., in a previously unreported letter obtained by ProPublica.

The letter came as the Fed was launching a “stress test” to decide whether the biggest U.S. financial firms could pay out dividends and buy back their shares instead of putting aside that money as capital. It was one of the central bank’s most critical oversight decisions in the wake of the financial crisis. “We strongly encourage” that the Fed “delay any dividends or compensation increases until they can show” that their earnings are strong and their assets sound, she wrote. Given the continued uncertainty in the markets, “we do not believe it is the right time to allow transactions that will weaken their capital and liquidity positions.”

Four months later, the Federal Reserve rejected Bair’s appeal. In March 2011, the Federal Reserve green-lighted most of the top 19 financial institutions to deliver tens of billions of dollars to shareholders, including many of their own top executives. The 19 paid out $33 billion in the first nine months of 2011 in dividends and stock buy-backs.

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The Fed allowed the largest financial firms to pay out $33 billion to shareholders last year, money they won't have to cushion themselves if a new crisis hits. That $33 billion is money that the banks don’t have to cushion themselves – and the broader financial system – should the euro crisis cause a new recession, tensions with Iran flare into war and disrupt the oil supply, or another crisis emerge.

This is the first in-depth account of the Fed’s momentous decision and the fractious battles that led to it. It is based on dozens of interviews, most with people who spoke on condition of anonymity, and on documents, some of which have never been made public. By examining the decision, this account also sheds light on the inner workings of one of the most powerful but secretive economic institutions in the world.

The Federal Reserve contends it assessed the health of the banks rigorously and made the right decisions. The central bank says the primary purpose of the stress test was to assess the banks’ ability to plan for their capital needs. The Fed allowed only the healthiest banks to return capital — and they are still not paying anything like the proportion of profits that they distributed in the boom years. And it says the stress test covered only one year. Regulators say they can revisit their decisions if the economic picture turns bleaker.

Most important, Fed officials argue that the biggest financial institutions still added $52 billion in capital to their balance sheets in 2011 despite raising dividends or buying back stock. The top 19 financial firms had a 10.1 percent capital ratio by the end of the third quarter of 2011, using the measure that regulators primarily look at, nearly double what they had in the first quarter of 2009.

But a wide range of current and former Federal Reserve officials, other banking regulators and experts either criticized the decision to allow dividend payments and stock buy-backs then, or consider it a mistake now. Among their reasons: Allowing banks to return capital to shareholders weakened American banks’ ability to withstand a major shock. Whether they are too weak remains debated, but dividends and buy-backs matter. From 2006 through 2008, the top 19 banks paid $131 billion in dividends to shareholders, according to SNL Financial. When the financial crisis hit, the banks were weak in large part because they didn’t have those billions. Indeed, in the fall of 2008, the government invested about $160 billion in the top banks.

Today, the European economic and banking crisis, which was looming when the Fed made its decision, continues to threaten the economy. Unemployment in the U.S. remains persistently high, and the housing market fell almost 5 percent last year, according to CoreLogic, a financial information firm.

American banks are suffering metastasizing liabilities from the U.S. foreclosure crisis. A recent settlement with almost all states’ attorneys general covered only part of those costs, leaving many banks bleeding cash to cover legal costs of the robo-signing scandal and other problems related to the housing crisis.

Once banks start paying dividends, it’s difficult for a regulator to get them to stop without panicking investors. Indeed, building investor confidence was one reason the Fed allowed dividends. But by that measure, it failed: This past November, ratings agency Standard & Poor’s downgraded most of the biggest American banks, and financial stocks in the S&P 500 plummeted more than 18 percent in 2011, though they have since bounced back a little.

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