Fed Shrugged Off Warnings, Let Banks Pay Shareholders Billions

Posted on Mar 3, 2012

DonkeyHotey (CC-BY)

The Federal Reserve building in Washington.

By Jesse Eisinger, ProPublica

(Page 3)

In late 2009, regulators decided that the eight financial institutions that hadn’t exited TARP immediately after the first stress test, including Bank of America, Wells Fargo and Citigroup, would be able to pay back every $2 of TARP money by issuing $1 in new common equity, according to a Sept. 29, 2011, report by the special inspector general of TARP. The banks could raise the other dollars through other ways, such as borrowing.

Yet, almost as soon as they had decided on that standard, the Federal Reserve and OCC relaxed it for some of the most troubled big banks. The FDIC “was by far the most persistent in insisting that banks raise more common stock,” the report found.

The FDIC pushed repeatedly for the banks to adhere to the guidance known as the “2-for-1” provision.

Sheila Bair’s agency was particularly frustrated when the Fed and OCC eased their conditions for Bank of America, one of the most vulnerable banks.

Bair told the TARP special inspector general that “the argument [the Fed and OCC] used against us —which frustrated me to no end —is that [Bank of America] can’t use the 2-for-1 because they are not strong enough to raise 2-for-1.” She said: “If they are not strong enough, they shouldn’t have been exiting TARP.”

The Fed decided it could ignore the FDIC’s views. On Nov. 19, 2009, an unnamed Federal Reserve governor stated that Bernanke’s position was that “we would go ahead without [FDIC] agreeing,” according to a previously unreported email from a draft version of the special inspector general’s report. And indeed, Bank of America fell more than $3 billion short of 2-for-1, raising $19.3 billion in equity to pay off the taxpayers’ $45 billion.

Since then, Bank of America has run into further troubles and been forced to sell assets and raise capital.

The Fed has taken pains to hide such tussles and compromises. The email describing Bernanke’s decision to override the FDIC, along with many others, was excised from the final draft of the special inspector general’s report. In a footnote in the final, published report, the special inspector general wrote that the Federal Reserve “strenuously objected to the inclusion of a significant amount of text” in earlier versions of the report, citing the need to keep communications with banks confidential.

Even though the special inspector general wrote that she “respectfully disagrees” with the Fed, she allowed the emails to be excised from the published report.

Stresses during the stress test

In 2010, as the Fed began the second stress test, officially known as the Comprehensive Capital Analysis and Review (CCAR, pronounced “See-Car”), bankers lobbied heavily to be allowed to return capital to shareholders. They began to feel emboldened to speak out against tightening regulations.

In late 2010, Tarullo had at least two conversations about capital planning, not previously reported, with top bank CEOs: JPMorgan’s Jamie Dimon and Citigroup’s Vikram Pandit. Dimon pressed Tarullo about the Fed’s plans for how much capital large banks should be required to have. The JPMorgan CEO, who has been an outspoken critic of the post-crisis regulatory tightening, argued to Tarullo that “it made sense to differentiate between banks,” says a person familiar with the discussion. “If we were healthy, we should be allowed to pay dividends and buy back stock.”

Bank executives such as Dimon and Pandit stood to gain personally from dividend decisions since much of their compensation comes in the form of stock.

Tarullo says he and the Fed were not unduly influenced by Dimon, Pandit and others who lobbied on behalf of the banks.

Inside the Fed, whether to pay dividends had been hotly debated for years. Less than a year after the height of the crisis, in August 2009, top officials from around the system met with Tarullo in Washington, where they mulled letting banks return capital to shareholders. Some Fed officials were shocked that the regulators were considering returning dividends so soon, according to one attendee.

Margaret “Meg” McConnell, a wiry and intense macroeconomist from the New York Fed, raised the possibility that the Fed might bar even healthy banks from paying dividends, if the regulator thought the environment was still too fragile. This is dubbed a “macroprudential” approach. Generally mild-mannered, McConnell surprised people with her emotion. She spoke “with a bit of pique,” a person at the meeting recalls.

But other Fed officials at the meeting argued that could be dangerous because it would erode investor confidence. They feared such an action might inadvertently signal that the Fed was still worried about the financial system. Preventing even ostensibly healthy banks from returning capital for a period of time might be destabilizing in and of itself. Investors could get the wrong idea and panic.

There were other debates. The European crisis, while not as acute as it would become in 2011, was clearly brewing by the time the stress test began in late 2010. Some supervisors argued that the test should include an evaluation of the banks against some European measure, such as a stock-market index, and make it public. In the end, that was rejected. The Fed worried about creating political backlash by suggesting Europe was in deep trouble, according to a person familiar with the discussion.

“It was important for us to create a regular, annual process to ensure that banks could only increase dividends or buy back shares if they could show they would remain healthy even in the face of adverse economic conditions,” Tarullo says to ProPublica. “It’s not reasonable to say that a bank could never return capital to its shareholders, no matter how well-capitalized it has become, but it is reasonable to require that any such action be premised on a sound capital plan and rigorous stress testing.”

The Fed’s legal department acted as a break on aggressive supervisors. The department, headed by the powerful general counsel, Scott Alvarez, had long served as a de facto overseer of supervision in Washington. The board of governors often asked Alvarez to report on various supervisory topics.

Tarullo appeared frustrated by this back-channel reporting and tried to curtail it, according to people familiar with the workings of the board of governors. He clashed with the legal department, viewing it as too friendly to the banks.

As supervisors conducted the second stress test, the legal department assessed whether the Fed had the authority to stop banks from raising their dividends—a move that surprised some supervisors because the banks themselves had never raised such an objection to the Fed’s power. After all, the Fed has statutory responsibility to maintain the “safety and soundness” of banks. Some staffers interpreted the legal department’s action as a sign that the Fed was looking for ways to hamstring itself, a signal that they should tread lightly when it came to restricting banks from returning capital to shareholders.

The Fed declined to comment and didn’t make Alvarez available.

Once Dodd-Frank was passed in the summer of 2010, making bank supervision a more vital part of the Fed’s mandate, the board of governors wanted to monitor Tarullo’s efforts, so the board requested regular briefings. One governor, Kevin Warsh, a George W. Bush appointee, viewed the Fed’s overall bank regulatory approach skeptically. Something of a libertarian, he thought that the Fed was overly confident in its abilities to monitor banking activities and head off crises before they became acute.

But Warsh, who oversaw financial market activities and not regulation and supervision, also worried that the banking system had too little capital. Do the banks have enough to offset losses? Do their books accurately value their assets? Do they have the proper risk management systems in place? he worried to colleagues. “There is too much confidence that these institutions won’t find themselves in the soup again,” Warsh tells ProPublica.

But the Fed had boxed itself in with its standard: The regulator had told the banks that if they hit their capital requirements under the stress-test scenarios, they could pay dividends and buy back stock.

Ultimately, the Fed did not allow every bank to increase dividends. Some banks, like Citigroup, didn’t request an increase after a signal from the Fed that it would be turned down.

In at least one instance, a signal was misinterpreted. Early in the process, the Richmond Fed left Bank of America with the impression that it would pass the stress test and be allowed to raise dividends. Encouraged, the bank asked permission.

In late 2010, Chief Executive Brian Moynihan suggested to investors that a raise would come in the second half of 2011. But in the end, the Fed nixed any dividend raise.  The Fed and Bank of America declined to comment on this incident.

A triumph for Tarullo, the episode nevertheless harmed investor confidence in Bank of America and its management, becoming one of the more embarrassing in Moynihan’s tenure at the bank.

The FDIC vs. the Fed

To some regulators, the second stress test seemed like little more than a formality with officials inclined from the outset to allow most banks to return money to investors.

“Institutionally, the decision was already made” before it was completed, says a former senior regulator who was involved in the testing. A Fed spokeswoman says that was not true.

Still, when a senior regulator familiar with the FDIC’s thinking heard that the Fed was considering allowing banks to return capital to shareholders, “my first reaction was: You’ve got to be kidding me. We are still in the middle of the crisis,” the official recalls. “We believed the banks didn’t have the structure for capital distribution, for dividends and stock buy-backs.” The stress tests “continued to get better, but they were not picking up the full gamut of risks.”

The banks had portfolios of underwater mortgages, and growing legal problems stemming from their pre-crisis actions and post-crisis foreclosure practices. Given the ongoing uncertainty about the global economy and the fragility of the world’s financial system, FDIC officials repeatedly voiced concerns to their Fed counterparts.

As the Fed began the test, Bair wrote her Nov. 5, 2010, letter to Bernanke. “We would prefer to see a longer period of stability, sustained core earnings growth, and strengthening of capital buffers before dividends are considered,” she wrote.

The letter pointed out that “once the level of dividends increases, it is difficult to scale back.”

One major concern was accurately measuring legal liabilities. Banks that had assembled mortgage-backed securities often faced accusations of fraud or deception from investors in those securities. Now, the banks faced a threat that courts would force the banks to take back billions of dollars’ worth of toxic mortgages, known as “put-back” risk. With input from the legal department, the Fed had come up with a system-wide estimate for this risk that the FDIC considered too low, according to two people familiar with the process.

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