Big Banks May Not Be Your Best Bet: Part 1

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The economic meltdown of 2008 and the subsequent taxpayer-funded bailout of the financial sector still haunts the world economy, although some bright spots have shown that the battered economy may be limping toward vitality again. Unemployment is down, employment numbers are improving, and consumers are starting to open up their wallets again. Just about a year ago, the federal government judged that shaky banks were stable enough to begin buying back stock and paying dividends, after a nearly three-year hiatus. But were they, really?

Propublica reports that 19 large banks paid out at least $33 billion in buybacks and dividends in 2011, even though their financial cushions were pretty flat. This means that these institutions may not have enough cash on hand to dig themselves out of another crisis situation, should one arise.

Sound familiar?

Despite words of caution, the plan went forward
But, you may ask, why would the feds allow them to do this if they were not sound enough? As it turns out, there were many well-informed parties that advised against allowing this change. In late 2010, the head of the Federal Deposit Insurance Corporation, Sheila Bair, strongly suggested waiting until the banks could better prove their solvency. In an interview with Kiplinger's in June 2011, Anat Admati, a well-regarded professor of finance and economics at Stanford, stated unequivocally that "banks are still funding themselves with too much debt." She went on to equate this situation with a borrower who puts very little money down on a house and then loses out when the house's value falls. Apt comparison, that.

Despite these warnings, banks were given the all-clear to commence with dividend payments in March 2011. The "stress tests" the government administered to ascertain the banks' fiscal readiness to start payouts was cloaked in secrecy. Another issue was that various Federal Reserve banks seemed to be rooting for the banks under their scrutiny, possibly in the throes of some type of Stockholm-syndrome effect. For instance, the New York Fed went to bat for Goldman Sachs (NYS: GS) , JPMorgan Chase (NYS: JPM) , and Citigroup (NYS: C) ; the Richmond Fed stumped for Bank of America (NYS: BAC) , and the San Francisco Fed cheered Wells Fargo (NYS: WFC) . All but Citigroup are near the top of the list as those who paid out the most in dividends for 2011.

Of course, the government's decision was accepted gleefully by shareholders and, most of all, bank CEOs, who could now crow that they were out from under the regulatory stare of the federal government -- and that's not to mention the big dividend payments they stood to receive, as well.

There's no escaping that paying out dividends and buying back stock uses equity that could function as a buffer against future problems. That being said, some have questioned the need to rush into these payouts. Though banking officials claimed that being unable to pay dividends restricted their ability to raise capital, the issue of whether they had enough capitalization to resume dividend payments was the crux of the matter. Chicken-and-egg argument, anyone?

New problems are cropping up as well. Some of these banks are now under fire for their role in the "robo-signing" scandal and other inappropriate foreclosure practices. It appears that Bank of America, Wells Fargo, and JPMorgan Chase could be expected to fork over billions to mortgagees who were unfairly subjected to the foreclosure process. For Bank of America, whose exposure to bad loans was magnified when it acquired Countrywide Financial back in 2008, this could be particularly bad news.

One year later, what does it all mean?
It is certainly understandable that both the Fed and the banks wanted to move on, leaving the shadow of the meltdown behind them. But it was chancy to do so when these changes could land both the banking sector, and the taxpayers by default (literally), right back in the soup. Surely, no one wants to replay the events of 2008; unfortunately, there is no guarantee that it can't -- and won't -- happen again. The whole bailout issue still rankles, and it's anybody's guess whether another one would fly, if the need arose. Either way, that's bad news for taxpayers, who would probably wind up cleaning up the mess or suffering higher unemployment, as well as investors -- who could wind up paying twice.

What, then, is a banking-investment aficionado to do? The big banks aren't the only players on the board, so exploring the profiles of smaller institutions is certainly an option. Until the big boys can offer up some numbers that make investors smile rather than wince, it can't hurt to take a look at the smaller regional banks, some of which have been doing quite well both on and off the board. In Part 2 of this article, I'll do just that.

Find out why those in the know look to the financial sector for their investments by checking out our free report, "The Stocks Only the Smartest Investors Are Buying."

At the time this article was published Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo and has created a covered strangle position in Wells Fargo.Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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