What's Really Wrong With Letting Big Banks Pay Bigger Dividends

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The Federal Reserve is finally -- albeit only implicitly -- admitting that not all the big banks are healthy: The Fed isn't letting Bank of America pay increased dividends.

When the Fed allowed other large banks to issue increased dividends last Friday, I asked why. The big banks are insolvent, because -- at a minimum -- their loan portfolios are wildly overvalued. The reason the banks aren't bankrupt despite their insolvency is because the government stands behind them. Since the banks are in such shaky financial straits, they shouldn't be paying out money they don't have as dividends. Period.

Yet the Fed let many of these the banks reward shareholders -- who, under reality-based accounting, would have been wiped out -- with money that could otherwise be used to help the banks become solvent. Investors aren't entitled to returns on their capital. Even Treasury bills theoretically involve some risk that investors won't get their money back.

The official rationale for the increased dividends is that they may allow the banks to attract new investors, which should allow the banks to make more loans. The logic of this escapes me. First, if the banks have sufficient capital to greatly increase their dividends and buy back shares, they have enough capital to make a meaningful amount of loans. I don't see why another step is required before the socially important increased lending might happen.

Either Banks Need Money, or They Don't

To those who might say that the current dearth of loans reflects a lack of demand, well, how about deploying that "excess" capital to make meaningful home loan modifications? Such modifications would also be economically useful, as keeping people in their homes instead of putting them through foreclosure could help the real estate market limp a bit more quickly toward recovery. There's no shortage of demand for meaningful loan modifications.

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And, if it were necessary to attract new investors to make loans, why didn't the Fed make the increased dividends conditional on increasing lending or meaningful modifications? The Fed has the leverage to do either, or even both. (Remember, the reason the Fed has control over the dividends in the first place is that such control was one price of the financial bailout that kept the banking system from failing.)

But the fact that really puts the lie to the idea that higher dividends are necessary to spur lending is the fact that share buybacks are being allowed. As the blog Baseline Scenario explains, buybacks are the equivalent of saying "we have more capital than we know what to do with." A bank can't simultaneously have more capital than it knows what to do with, and also need to attract more money before it can make loans.

Dividend Winners? The Executives, Of Course

Of course, the banks do know what they're doing with buybacks -- enriching their executives, who not coincidentally, make the decision to do the buybacks in the first place. Unlike dividends, share buybacks increase shareholder wealth by increasing the stock price, and thus are not directly taxed. For investors like executives, who have huge amounts of shares, that difference is meaningful. In addition, increased share prices can make executives' stock options more valuable, or earn them bonuses and other types of compensation.

Nonetheless, the executives would have to cash in while the increased share prices last: It's no mystery that future events could wipe out any gain from a buyback -- an impact that paying the cash out as dividends would avoid. And that risk again underscores how much worse allowing buybacks is than allowing dividends.

Drawing the line at Bank of America (BAC) is a positive step, but it's not enough. Bank of America's troubles, a large portion of which can be traced to its acquisition of Countrywide, are so well known that not even the most bullish, want-to-believe investor could swallow stress test results that gave it a clean bill of health. But Countrywide wasn't the only out-of-control lender. Consider what the FDIC says about Washington Mutual, which JPMorgan Chase (JPM) acquired.

So thanks, Fed, for forcing Bank of America to hang onto its capital so that it can perhaps cover its liabilities. But one reality-based decision does not a good policy make.

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