Letting banks boost shareholder dividends risks another bailout

leverage equity

By green-lighting more shareholder dividends, the Fed has allowed banks to increase leverage, which could lead to needing another bailout. Image: CC Flickr/TheTruthAbout

Bank of America quarterly dividends will stay stuck at only 1 cent for the rest of the year on order from the Federal Reserve Wednesday. However, last week after the Fed conducted stress tests on the biggest U.S. lenders it allowed many major banks other than Bank of America to increase shareholder dividends. Many financial analysts are concerned that the Fed’s decision to allow any bank to increase shareholder dividends poses an undue risk to economic recovery.

Fed throttles Bank of America dividends

In January Bank of America told the Federal Reserve it wanted to initiate an increase in shareholder dividends in the second half of 2011. The bank was expected to raise its quarterly dividend by up to 8 cents, about 20 percent of its anticipated earnings this year. According to analysts, the Fed forbid B of A from doing so because of the bank’s exposure in the housing market after buying out Countrywide in 2008, a decision that cost it $2.24 billion last year. Investor groups have also been pressuring B of A to buy back billions in bad mortgage securities that the bank foisted on them before the meltdown. After the green light from the Fed, JPMorgan Chase, Wells Fargo and U.S. Bancorp quickly announced dividend hikes. Bank of America said it planned to submit a revised dividend proposal to the Fed by the end of June.

Why banks want to increase shareholder dividends

Wall Street banks say without increasing dividends they will have a hard time raising more equity in the future, which they say will hold back economic growth. By paying shareholder dividends, banks attract investors but lose equity. Bankers disdain equity and love leverage. While a company like Google is funded almost entirely by equity, the average bank lives on other people’s money, funding more than 95 percent of investments with debt. Banks avoid equity because their executives and shareholders make big money on leverage as long as the financial services sector is healthy. Banks also avoid equity because the more equity they hold, the more liable they are for the risks they take. If things go sour, they have to reduce the risk of default at their own expense, rather than count on taxpayers to bail them out.

Fed decision risks another bailout

During the financial crisis, highly leveraged banks caused alarm at the Fed. Some analysts believe the Fed needs to allow the economy to get stronger before allowing increases in shareholder dividends. Simon Johnson of the New York Times compared a highly leveraged bank to buying a house with a minuscule down payment on a mortgage for 98 percent of the purchase price. If home prices rise, the risk pays off. If they drop, the borrower is quickly underwater and creditors get the shaft. The difference, however, between highly leveraged banks and highly leveraged homebuyers is that the banks have learned they are too big to fail. When a highly leveraged bank fails, a government bailout rescues its executives, shareholders and creditors, and U.S. taxpayers get the shaft.

Sources

New York Times

Business Insider

CNNMoney.com

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