Stress Tests and Bank Dividends

According to an article in the Wall Street Journal, the nineteen large banks that were subject to government stress tests in 2009 needed to submit new capital plans to the Fed by January 7, 2010 if they are going to be allowed to raise their dividends to as much as 30% of their post tax net income or repurchase stock. [emphasis added]

The Fed, after a review of the plans that is expected to take about three months, is likely to permit a large group of these financial institutions to raise their dividends, analysts say.

"This stress test is going to provide the Fed the political cover to say it's OK for some banks to issue dividends. The Fed will allow the stronger banks such as Morgan Stanley and Wells Fargo & Co. to issue new dividends," said Nancy Bush, financial industry consultant at NAB Research.

"There may be some in the next tier down where you have had progress on earnings but they are not back to a normal earnings environment, where the Fed will want to have a second look before approving dividend hikes."

This is a classic example of the Fed continuing to violate FDR's framework for the role of government in financial markets.  This framework lays out what governments should do and what they should not do.  They should make sure that all useful, relevant information is made available to market participants in an appropriate, timely manner.  They should not endorse an investment.

With the stress tests and related dividends, the Fed manages to violate both what it should do and what it should not do.

First, the Fed does not provide the asset-level data on each bank necessary for market participants to determine the capital adequacy of each bank and the appropriateness of dividend payments or stock repurchases.  Given its track record before the credit crisis of freely letting the banks issue dividends and repurchasing stock which resulted in an undercapitalized banking system when the credit crisis hit, why should market participants believe the Fed will properly judge the capital plans?

Second, the Fed is explicitly endorsing an investment in the banks that it lets issue dividends or repurchase their stock.  It could not be clearer that the Fed is saying that the banks which can pay a dividend or repurchase shares have adequate capital and the other banks do not have adequate capital.

All of this is raising competitive concerns with those financial institutions worried they won't be permitted to raise dividends.

"It may have a greater impact than just the dividend issue," said Dwight Smith, partner at Alston & Bird LLC, in Washington. "Some banks may be perceived as unhealthy." 

...The Fed said in a statement that big banks must repay TARP funds and satisfy other conditions related to TARP before the central bank can consider letting them take other capital actions.

...Alston's Mr. Smith agreed that the Fed will likely approve some dividend increases. "I don't think the Fed would have gone through this exercise unless they would approve some dividends."

Finally, the stress tests highlight the degree of government involvement in supporting the banks that the Fed is going to declare have adequate capital for paying dividends or stock repurchases.  For example, one of the factors in determining capital adequacy is the potential for mortgage or mortgage backed securities put-backs to the banks.  Not to imply a link, but the timing of the settlements between two banks subject to this round of stress tests and Fannie and Freddie is interesting.

Once the plans are submitted, the Fed plans to evaluate each institution based on how they plan to fulfill Basel III capital requirements, under which banks must eventually hold top-quality capital totaling 7% of their risk-bearing assets.

The Fed said banks must take into account risks on the horizon, such as their ability to absorb losses on litigation and other costs, including suits from investors seeking to force banks to repurchase or "put-back" bad mortgages the banks sold them. Bank of America, for example, is being sued by investors including the New York Fed that demand the lender purchase $47 billion worth of mortgages.

The Ibanez decision by the Massachusetts Supreme Court, dramatically changes the Fed's test for capital adequacy.  The question of "were all mortgage backed securities that included Massachusetts mortgages fraudulently sold" is now on the table and must be included in the Fed's stress tests.

There is now a possibility that banks will have to repurchase these RMBS securities.  It was represented to investors that the securities were backed by Massachusetts mortgages and the court decision says that was not the case because the pooling and servicing agreement was not adhered to.  Given this court decision, prudence suggests that retaining the maximum amount of capital in the large banks is a good idea given the sheer size of the potential losses on these RMBS securities if the banks are forced to repurchase them.