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Fed Shrugged Off Warnings, Let Banks Pay Shareholders Billions
Posted on Mar 3, 2012
By Jesse Eisinger, ProPublica
Worse, by the fall of 2010, banks had an emerging legal threat to worry about: foreclosure problems. In the aftermath of the housing crash, banks had abused the rights of homeowners in the process of foreclosing. The most publicized issue was “robo-signing,” in which banks had documents automatically notarized by people who weren’t reading the materials or checking for inaccuracies. As this threat emerged, banks came under investigation by state attorneys general and faced billions in new potential legal liabilities.
“The highly publicized mortgage foreclosure process flaws provide an example of how quickly material issues can arise in these institutions and how they are still exposed to the poor decisions made in the years leading up to the crisis,” Bair warned Bernanke in her letter.
Estimating these future liabilities was a task the Fed delegated mainly to the banks. In a Dec. 12, 2010, speech, Tarullo said the Fed expected “that firms will have a sound estimate of any significant risks that may not be captured by the stress testing, such as potential mortgage put-back exposures, and the capacity to absorb any consequent losses.”
But the various foreclosure problems were just emerging, so estimating those liabilities was difficult—though it was clear that they could be huge.
Square, Site wide
The FDIC was puzzled. “The direct connection between the put-back issue and the stress test never has been clear to me. They didn’t take the number and add it to the bottom line,” says the senior regulator familiar with the FDIC’s position. “They didn’t have any sizing on broader servicing liabilities.”
All the more reason, FDIC officials thought, to slow down the dividend payouts and stock buy-backs.
The Fed did have an effort parallel to the stress test to assess these liabilities, and, according to a Fed spokeswoman, eventually included the legal risks in the stress test.
(In February, banks settled robo-signing problems with state attorneys general for $25 billion but remain on the hook for other legal liabilities arising from their mortgage servicing.)
By March 2011, it was clear the FDIC had lost its argument. The stress test was winding up, and most of the big banks would get a green light. The agency made a last stand on one bank: SunTrust, a large regional bank based in Atlanta.
The Fed had determined that SunTrust passed the stress test and could exit TARP. Bair appealed to Tarullo, according to several people familiar with the matter. The objection has not previously been reported.
The FDIC didn’t think SunTrust was ready to pay back the government and leave the program. It was one of the last big banks to still have TARP money. It was loaded with high-risk assets, such as interest-only, adjustable-rate mortgages and loans to borrowers with low credit scores.
But the Fed shunted aside Bair’s appeal and allowed the bank not only to repay the government but to do so on indulgent terms that the FDIC thought left SunTrust still vulnerable. When it green-lighted SunTrust’s exit, the Fed didn’t adhere to the 2-for-1 replacement standard regulators had established for healthy banks. The bank issued only $1 billion in new common stock to repay the government’s $4.85 billion in preferred stock.
The FDIC had lost again.
Two former Fed officials who held senior posts during the crucial decision-making say they were troubled, believing that SunTrust didn’t have enough capital. “I was horrified,” says one of the officials.
Since then, investor views have mirrored those of the Fed’s critics. In 2011, SunTrust shares tumbled more than 41 percent. The bank has a market value of about half of the value of the assets on its balance sheet —a sign that investors suspect the bank is overstating the worth of its assets and exaggerating its overall health.
SunTrust and the Fed declined to comment.
Some see allowing dividends and stock repurchases as a confidence-building exercise. The hope is that investors will believe that the Federal Reserve is confident in the banks and will buy bank stocks. Higher share prices mean that banks can sell stock more cheaply if necessary. The regulators’ logic seems to have been: Let the banks deplete capital to raise capital.
In the second stress test, “how much was appearance, and how much was reality? The Fed wanted the appearance of strength,” says a former senior regulator. “The Fed wanted everyone to see that the banks were profitable, back to normal and back on the road to health. ... And the banks wanted it.”
Passing the banks makes the Fed look good, too. The Fed “wanted it as a symbol of their success in mending the banks,” the senior regulator says.
Tarullo strongly defends the decision to allow some of the banks to return capital to shareholders.
“If you imagine a truly severe financial dislocation, it’s not going to matter much for the health of the U.S financial system whether banks paid out five or eight percentage points more of earnings in the preceding year,” he says. “What will matter is that the banks have been steadily building capital to much higher levels than existed before the financial crisis and that they are subject to annual stress tests to make sure they have the capital needed to withstand a quite adverse economic situation.”
Indeed, the Federal Reserve is at it again, conducting another stress test of the biggest banks. The Fed is testing the banks against much more dire scenarios than it did a year ago, which some analysts see as an implicit admission that it was too soft in the earlier test. This time, in order to comply with Dodd-Frank, the Fed must make much greater disclosure of how the tests are conducted and which banks pass.
The tests are draconian. They require the banks to plan against a scenario in which, among other drastic occurrences, the Dow Jones Total Market Index crashes to 5,668 and gross domestic product falls four quarters in a row, including one 8 percent quarterly drop, almost as much as it did in the fourth quarter of 2008, and unemployment rises to more than 13 percent. Can any of the banks truly survive such a scenario? And will the weaker ones be restricted from buying back stock or paying dividends?
The Fed seems to have put itself in a bind. Either the banks don’t pass, which could harm investor optimism and thus the fragile economic recovery. Or the banks somehow do pass, risking the Fed’s credibility in the event of another crisis.
The results will be out in mid-March.
Correction: A previous version of this story incorrectly dated the letter from Anat Admati to the Financial Times. The letter was published in February 2011. It also misstated the name of a stock index the Fed is using in its new stress test, scheduled to be completed this month. A scenario the Fed is using involves the Dow Jones Total Market Index crashing to 5,668, not the Dow Jones Industrial Average.
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