Dividend Lost

By Simon Johnson

Four types of people were directly affected by the Federal Reserve’s decision at the end of last week to allow major banks to increase their dividends and to buy back shares.  Three of these groups – bankers, bank shareholders, and government officials – were somewhere between happy and delighted.  The four group, US taxpayers, should be much more worried (see also this cautionary letter to the Financial Times by top finance academics).

The bankers’ reaction is obvious.  They are officially released from the financial hospital ward that was set up for them in 2008.  No matter that this was a very comfortable place with few conditions relative to any other bailout in recent US or world history – there were still restrictions on what banks could do and, naturally, bank executives chafed at these constraints.

In particular, banks were required to build up the equity in their business – insolvency is avoided, after all, while there is positive equity in a business.  When shareholder equity is exhausted, creditors face losses.

You might think that the people who run banks have an incentive to keep equity at a high level – providing a cushion against future losses and effectively protecting creditors.  And banking did operate in this fashion back when government was much smaller and effectively unable to save large financial institutions.

But that was in the nineteenth century – when banks had capital levels in the range of 30-50 percent (and functioned fine at that level).  In the twentieth century, the equity in banking has tended to decline relative to debt; this is what it means when people say leverage has gone up.

A thinly capitalized bank is like buying a house with very little money down and a mortgage for 98 percent of the purchase price (and such levels of leverage, up to 50:1, were common in the run-up to 2008).  If the house price goes up, you have done very well relative to your initial investment.   Of course, if the house price goes down, you are under water faster when there is less equity in the business – and creditors are more likely to face losses (depending on your cash flow and broader incentives to default.)

The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged.  Bank executives and other key personnel are paid on a “return on equity” basis, so this increases their upside, i.e., what they will make as long as the economy and their sector does well.  (Look at Figure 2 on p.15 of the just updated paper by Admati, DeMarzo, Hellwig, and Pfleiderer; their analysis has become central to the debate.)

Up to a point, this also makes bank shareholders happy – their equity (left in the business) will have more leverage and therefore also higher upside.  The shareholders should, of course, worry about the bank executives taking on more leverage than is optimal from an owners’ point of view, but it really does not seem that even the more articulate shareholder groups are paying sufficient attention, e.g., to who supervises risk management at the board level.

And if the bank is presumed “too important to fail”, there is considerable downside protection for bankers and their shareholders – as well as for the creditors.

One group that should be more concerned about this arrangement is those government officials who are directly charged with ensuring financial system stability and who are well aware of the externalities involved in bank capital decisions.  Any individual bank will want to keep its equity levels low – because its executives and owners are not worried about system-wide spillover costs, i.e., what happens to other banks when any one bank fails.

The Fed was naturally worried about bank equity during the crisis – most officials were unhappy, for example, when banks paid big bonuses in 2008 and 2009; higher wage compensation means lower bank profits and hence less shareholder equity (before the decision on whether this should be retained or paid out).

The Fed has also agreed to the higher capital requirements of Basel III (although these are not enough).  And, by all accounts, it will impose some form of “capital surcharge” on the country’s largest banks (the details are not yet announced, but these are also unlikely to prove sufficient).  The term “surcharge” is a misnomer; this is not any kind of charge or tax, but really just the requirement that big banks finance themselves more with equity relative to debt – because of the dramatic ways in which they can damage the system.

Yet the impression conveyed by Fed officials last week was more one of triumph than the wary caution that one would expect.  Our nations’ leading practical thinkers on this issue have really convinced themselves that bank equity levels now are more than fine – so they can be reduced by payouts to shareholders.  This is despite the fact that the “stress tests” just used to this purpose are highly suspect because they were run by the banks themselves and the results will not be published in any detailed way; this is disturbingly similar to the European bank stress tests of summer 2010, which were a complete disaster (see Section V of the Fed’s technical paper, pp.18-19).

Top Fed officials really seem to think:

  1. The events of 2007-8 were rare and cannot happen again anytime soon.  “Do you really think supervisors could make the same mistake again?” is one refrain.  This ignores completely all dimensions of political economy (the power of banks) and cognitive capture (the power of ideas put forward by bankers).
  2. The Fed made money on their various and extensive interventions.  This is true, very narrowly defined, but such calculations are – as they should know – highly suspect because they are not risk adjusted.  Ask yourself this: if the Fed and other government officials were to repeat this kind of support for the financial system 10 or 20 times, how often would it go well?
  3. There are no other first-order costs worth considering.  This is outrageous and unacceptable – what about more than 8 million jobs lost and a deep recession that will end up increasing net federal government debt held by the private sector by around 40 percentage points of GDP?

The US taxpayer has a much greater burden of debt as direct result of lost tax revenues due to the deep recession; the Bush stimulus of 2008 and the Obama stimulus of 2009 had little effect relative to the loss of tax revenue, 2008-11.

But who in modern American political life really cares about the taxpayer?  Apparently not the Federal Reserve.

Perhaps just Senator Sherrod Brown (D., OH), a member of the Senate Banking Committee, who said on Wednesday,

“I’m concerned by both the process and the outcome of the Fed’s decision. How did the Fed conduct these tests, and how did each tested bank fare? What effects will this decision have on the current financial stability of these banks and their preparations to meet enhanced capital requirements in the coming years?  And why, in a time of slow economic growth, are banks increasing leverage rather than lending?

“Given the success of the first set of U.S. stress tests, and the failure of the more opaque European stress tests, the Fed should have been as open and transparent as possible with the American public.  Unfortunately, at this point its actions have raised more questions than they have answered.”

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

41 responses to “Dividend Lost

  1. Herbert Wetherby

    Oh, he’s in a pickle and does not know it, and will not admit it when the day arrives, for it would mean his own demise.

  2. I am glad they put a stop to the dividend increase at BAC, but they should have done so as well at JPM, WFC etc. If a bank is TBTF, its balance sheet has to be bulletproof, and I dont see any body armor on them, then again without mark to market accounting, who really knows. Here is my longer post on the issue:

    http://www.zacks.com/stock/news/49537/Big+Bank+Dividends+a+Bad+Idea

  3. “A thinly capitalized bank is like buying a house with very little money down and a mortgage for 98 percent of the purchase price (and such levels of leverage, up to 50:1, were common in the run-up to 2008).”

    We have seen that homeowners with no skin in the game tend to walk away from their responsibilities. Likewise the bankers.

    We have a corrupt and failed financial system. And I am incredulous that anyone in the Fed thinks that:

    “1. The events of 2007-8 were rare and cannot happen again anytime soon….

    2. The Fed made money on their various and extensive interventions…. [We cannot afford such "profitable federal adventures in banking ever again.]

    3. There are no other first-order costs worth considering….”

    I TRULY hope Simon’s assumptions re: fed beliefs are way off base, but somehow I think not…

  4. “This ignores completely all dimensions of political economy (the power of banks) and cognitive capture (the power of ideas put forward by bankers).” This does not ignore these dimensions. Actually, it implements the power of bankers and cognitive capture. If the power of bankers and cognitive capture were ignored, we might have coherent banking regulation.

  5. Mr. Isaac v. Ms. Admati: “A Coin Toss?”

    Note: ad-hoc analogy (JMO)

    “we often make the mistake, thinking of a coin as having but only two side;
    it is the third side that gives its depth, thus validity, that is sadly, often overlooked;
    a serious oversight that balances its weight, its equilibrium, regarding its worth;
    if we were to exact infinite decimal reduction; fraction by fraction depletion, whereas the overall vantage weakens the entities physical/social structure, the physic’s of real world known logical parameters come into play;
    the coin cannot stand on its own;
    laying on its face, its back collapses and melds into a singularity;
    a mirage, a blur, and illusion of what was once a two sided fallacy;
    indecipherable;
    but for only the magician’ mind?”

    Please realize that this is applicable for todays macro/micro economics thesis where rationale becomes almost opaque?

    Thankyou Simon and James

  6. Re. “I TRULY hope Simon’s assumptions re: fed beliefs are way off base, but somehow I think not…”

    Firstly (yet sadly in this case), as a former student of Simon’s I would be the first to suggest that he is seldom wrong.

    I also think that America long ago passed the tipping point of control on its national debt to the extent that Asian creditor nations – and most worringly China – have neutered its ability to make meaningful policy changes that might upset such powers – whether such reforms are in the areas of financial or foreign policy and regardless of whether it is the Fed or legislators who are to blame.

    With all this and other system-wide differences in place, I’m not sure the US could even implement the more risk-sensible financial policies of Canada, for example, and for which Simon seems to argue.

    Short of moving quickly toward a more centrally planned economy like that of China’s, which is not recommended for other obvious reasons, America’s (and frankly much of the world’s) real hope may be that it comes up with another of its famous inventions like the Internet that let it grow out of its current financial straits. Luckily, the creativity of its people has always been and remains its biggest asset.

  7. Ever wonder why Congress never intends to truly regulate banks? For a concise answer, look at what the kids of Senators and Congressmen do. Here’s Paul Pelosi, Jr:

    His LinkedIn profile is a bit incomplete. It discusses his investment-banking work for Bank of America and JPMorgan Chase. And it mentions his job at Countrywide, for example, where he worked as a loan officer — at one of the mortgage companies most scrutinized for its role in the housing bubble and ensuing collapse of Wall Street.
    But it pointedly omits his $180,000 a year job as a senior vice president at InfoUSA, a marketer of consumer databases, which he started less than one month after his mother became House Speaker, while simultaneously holding his job at Countrywide. InfoUSA CEO Vinod Gupta also paid Bill Clinton millions of dollars as a consultant, so many suspected Pelosi’s job was an attempt to win influence with Nancy Pelosi. Paul Pelosi’s explanation: He got to know Gupta as a client for whom he refinanced a house, and his experience as an investment banker was useful in evaluating acquisitions.
    InfoUSA is best known for peddling lists of seniors with gambling addictions and serious diseases like Alzheimer’s or cancer to opportunistic telemarketers. Gupta resigned as InfoUSA’s CEO in July 2008. Pelosi is not listed on the company’s investor-relations website as an officer of the company.
    Which raises the question: What was a former investment banker doing working as a mortgage loan officer, anyway?

  8. To other citizens outside the USA, the deep corruption infecting most segments of the economy, courts and governments has a price to pay as the internal contradictions will ensure it so.

  9. I often wonder what the word conservative means anymore. I had the impression it had something to do with traditional values and ebing somewaht risk adverse.

  10. Q. Who is going to lose the most on this capital reduction?

    A. The small businesses and entrepreneurs, because they consume the most of regulatory bank capital when being lent to, and there will be less bank capital to go around.

  11. Double speak seems to be working on you. You have openly stated you no longer know what some words mean.

    (In truth you actually do know the meanings. Defend the words and insist that those that try to abduct them are ignorant, corrupt, insane or some combination of the three.)

    If you want your world go down the drain, just watch my good man, just watch. (I am. But I’m on a tropical island of no importance to any world power.)

  12. Simon. What do you think about raising dividends and buying back stock to positively influence share prices as a less obvious way for bankers to increase compensation?? After all senior executives have significant net worth tied up in company stock, dividends are taxed much lower than earned in income and compensation is and will be under scrutiny for some time to come

  13. Stephen A. Boyko

    Per, you nailed it!!!

    “Q. Who is going to lose the most on this capital reduction?
    A. The small businesses and entrepreneurs, because they consume the most of regulatory bank capital when being lent to, and there will be less bank capital to go around.”

    So much for job creation and innovation. The intelligentsia is proposing that the under-employment of labor (unemployment) is to be solved by an under-employment of capital. A bank holiday is declared for capital until “banks are safely capitalized.” But, safe in relation to what?

    To make matters worse, academics and regulators are almost exclusively trained in deterministic disciplines such as law, accounting, and economics—with little evidence of training involving complexity theory, or mathematics involving randomness. If the world were as deterministic as this post suggests, then a 50:1 leverage ratio would suffice given the governance knowledge at hand.

    But, as I have argued before, in a world of financial innovation and bubbles, it is uncertainty — not risk — that should be the randomness component of focus. Otherwise, bad information leads to flawed pricing that creates “vapor assets”.

    Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift. Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?

    Similarly, collateralized debt obligations (CDOs) and credit derivative swaps were the subprime boom’s vapor assets where NINJA mortgagors were given property rights in order to enable questionable securitizations at even more questionable AAA-ratings prices to take place. But when the bubble burst, “questionable” became “improbable” as deterministic metrics lacked robustness to manage uncertain investments.

    Simply put, the same folks that were in charge of watching Madoff, were also in charge in valuing the hole-in-the-donut for the purpose of determining capital compliance. Is there any question as to why regulated industries become oligopolistic? If you want change, propose realchange.

  14. In the meantime, GE pays no U.S. tax in 2010.

    See: http://www.nytimes.com/2011/03/25/business/economy/25tax.html?_r=1&ref=business

    Just more evidence of the Corporatist Kleptocracy that has swallowed the U.S.

  15. @Stephen A. Boyko: “So much for job creation and innovation. The intelligentsia is proposing that the under-employment of labor (unemployment) is to be solved by an under-employment of capital. A bank holiday is declared for capital until “banks are safely capitalized.” But, safe in relation to what?”

    Indeed! And that is why I do not give a lot for the self-proclaimed mutual admiration clubs of financial regulatory “intelligentsia”, whether on the left or on the right.

  16. Stephen A. Boyko

    Amen to that! I have been called anything from an anarchist to a royalist apologia. If you are correct (as compared to right), it doesn’t matter. If you are incorrect, no one cares.

  17. Economists have a persistent habit of ignoring the political implications of their trade — that all individual humans do not fall on the same lines on their lovely aggregate equilibrium curves.

    Simon Johnson is trying to redress this omission, by pointing out that different groups of people have different interests in policy decisions. Here, the Fed (what a shock!) is favoring bankers and investors over ordinary Americans. Would you expect anything different from the Bernanke-Geithner axis?

  18. Stephen A. Boyko

    jakepgh

    “different groups of people have different interests in policy decisions”

    Agreed. Then perhaps you can persuade Dr. Johnson to challenge One-Size-Fits-All legacy metrics in favor of predictable, risky, and uncertain governance domains.

  19. For instance… on the side of the self-named progressives, one of their heroes, Joseph Stiglitz, who corners much of the debate space, has obviously not wanted to get his PhD’s hands dirty looking at the regulations in any major detail. As a consequence he has never understood how these regulations so outrageously discriminate against absolutely vital players such as small businesses and entrepreneurs; who currently not only have to face the natural discrimination the market does of those who like them are usually perceived as riskier, but they also have to fight the arbitrary bias against risk by plainly irresponsible bank regulators who never even ask themselves what the purpose of the banks they regulate should be.

    And on the side of the self-named conservatives… there most, instead of screaming bloody murder about a stupid regulatory interference in the market, find themselves in a sort of dumb trance looking solely at the (quite minor) role in this crisis of Governments Sponsored Entities such as Fanny Mae.

  20. Stephen A. Boyko

    Kurowski:

    Agreed! But until you differentiate risk from uncertainty, it is one hand clapping.

    Q. Knowing that you can insure but not hedge uncertainty, could you have sold uncertain no-money-down, NINJA subprime securities at risk prices?

    To your earlier point, is it not odd that conservatives choose regulatory means rather than market forces when pressed to solve subprime problems.

  21. I think whess is right. A profound sea-change seems to be happening to the meaning of “Conservative” — There are layers of meaning in the word, and sometimes those layers seem at odds with each other. And it is very strange that the working class has become increasingly conservative.

    I suspect this shift is occurring because the TRUE conservatives are now those whose imperative is to save the Earth from environmental degradation — and so the old “business & tradition” conservatives are no longer grounded upon the most basic values. The wealthy upper class establishment used to be associated with maintaining the status quo — ie what was “conserved” was not only wealth but also social stability. But now that old mentality is undercut by the growing awareness that our security actually rests in nature. Conservative and conservation. No wonder whess questions it.

  22. A generation and more ago, back to Teddy Roosevelt, the word “conservationist” was used for what you mean. The leading conservationists were hunters and fishermen and outdoorsmen and gun owners, long before it became part of “liberal” dogma. And long before it became part of gun owners dogma to oppose (by right-wing NRA reflex) conservation of the environment.

    This is an excellent example of how the Left and Right in the US have become divided when they should be sharing many values. They did it to themselves by shouting past each other rather than seeking common ground. And this was surely promoted by self-interested “advocacy” groups on both sides, whose own power depends on polarizing people.

  23. Especially the frickin media. They make their bread and butter by amplifying discord.

    Good point about the Teddy Roosevelt conservationists. Perhaps they still are around as Ducks Unlimited. In my town that is a “must-join” organization if you want to be part of the tightly-knit business community. Kind of functions like a secular church, on the social networking level — it stands somewhat independent of the big contributors because, like a church, it is in the service of a higher cause. This gives it a conservative stability, in the old sense of conservative. It is very well funded, for reasons I don’t fully understand. It is an interesting social invention. Perhaps in Teddy’s time something equivalent was going on.

  24. anandopadooda

    VERY interesting, anonymous. Ducks Unlimited is “Conservative” in both senses — bridging the shift in meaning — and is oddly influential among the property owners in your community. Where is that, if I may ask?

  25. What’s next? Looking ahead,…
    China’s Currency: “The Rise of the Redback (Renminbi/Yuan)” The Economist (1/20/11)
    http://www.economist.com/node/17959580

    *They love the (German) Euro?

    “Bailout Math leaves shareholders almost Zero” – The Deal by Allen Sloan (6/1/10)
    (ie. the greater fool theory via redundancy by PT Barnum?)
    http://www.money.cnn./2010/05/31/news/companies/bailout_shareholders_sloan.fortune/index.htm

  26. Noteworthy:

    Just out of curiosity? I’m wondering if we have a reciprocal “Something” with the foreign banks we bailed-out. That is to say. Are we buying their bank shares while they’re buying ours?
    Who’s to know? Help!

    “Federal Reserve’s Secret Taxpayer-Funded 12.8 Trillion (With a “T” folks) Bailout of Global Banks” – {Before it’s News (12/10/15)}
    http://www.beforeitsnews.com/story/310/856/Federal_Reserves_Secret_Taxpayer-Funded_12.8Trillion_Bailout_of_Global_Banks.html

  27. anandopadooda

    Wow. That’s scary.

  28. Herbert Wetherby

    It’s hard to say, I do know that in the end, we will at least break even.

  29. thanks for that.

  30. Very nice article. Where is the rage?

  31. It seems to me that paying dividends is meant to prepare for *raising* equity. Such a raise would also be a MUCH stronger statement of bank health than the Fed allowing dividend payments and carries political dividends for the Obama administration and the Fed as well.

    If true, investors (probably pensions and mutual funds held on behalf of us “little people”) will likely be lured into bad bank investments solely due to dubious Fed actions that attempt to put lipstick on the these pigs such as QE2-inflated earnings and resumption of dividend payments.

    BTW, HuffPost is reporting that 4 million people have moved their money from big Banks.

  32. It is a mystery to me why the number isn’t ten times larger.

  33. Apologize for all the links,…but

    Ref: “The BCCI Affair – 1 Executive Summary”
    This is dated material but time-tested for the perpetrators at “BCCI”: it has been given a “Good House Keeping” seal of approval as a living/breathing programmed text by the New World Order Banking Cartel!
    http://www.fas.org/irp/congress/1992_rpt/bcci/01exec.htm

    Ref: “Monopoly Money and the International Banking Cartel” (by dvrabel 8/12/10)
    Comments and language are quite diverse and lengthy
    for a good read relating to the subject matter.
    http://www.csper.wordpress.com/2010/08/12/monopoly-money-and-the-international-banking-cartel/
    PS. Hello Bruce :-)

  34. there’s rage police on this blog – see annie, carla and mondo conversation when carla called double entry accounting stupid and then annie said that the most interesting thing she learned was how the math of thermodynamics evolved from double entry accounting, which carla-with-a-cause didn’t like annie noting, and then the resident misogynist chimed in with a load of psychoanalysis about annie’s rage having something to do with a man’s animus or something…

  35. Herbert Wetherby

    Even though I could not find a date for that material, the answer remains the same. Subscribe to Clearing House Magazine and do not buy any lottery tickets.

  36. Hi, Annie

  37. markets.aurelius

    What is a TBTF/TBTS guarantee worth? Why not give all the federal money gusher to shareholders when you can do anything, take any risk, and continue to prosper like never before? Because you can … like never before, as the FT once again notes ( http://www.ft.com/cms/s/0/1c0e0faa-5963-11e0-bc39-00144feab49a,s01=1.html#axzz1Hyx5hycW ):

    “Moody’s raises alarm over $20bn loan to AT&T

    “By Justin Baer and Helen Thomas in New York
    Published: March 28 2011 19:08 | Last updated: March 29 2011 00:01

    “JPMorgan Chase’s $20bn bridge loan to finance AT&T’s acquisition of T-Mobile USA is a “credit negative” that might encourage banks to take on outsized risks to win underwriting fees, Moody’s Investors Service has warned.

    “The credit-rating firm warned that similar risks had surfaced during the second half of 2007, after the leveraged-loan market had seized up and the financial-services industry began its descent into crisis.”

    We are living is an insane world right now. Maybe everything does come to an end in 2012. JP certainly is acting that way.

  38. markets.aurelius

    Oh, yeah: The punch line from the FT: “Moody’s said the loan was large, “even by JPMorgan standards”, accounting for 17 per cent of its tier 1 common equity – its highest quality capital – and unusual for its concentration within one bank. By contrast, 11 banks shared a $15bn financing commitment for Sanofi-Aventis’s October 2010 acquisition of Genzyme.”

    Who needs capital when you’re TBTF? JP can lend almost 20% of its Tier 1 to a firm in a market with next-to-zero barriers to entry, and pay away dividends like they’re actually making money and creating value … because they can … the money gusher never stops!

  39. Stephen A. Boyko

    “What is a TBTF/TBTS guarantee worth?” I believe is getting at the correct question.

    Consider — TBTF scale provides tutorial governance that does not meet real-world requirements. In a world of financial innovation and bubbles, it is uncertainty — not risk — that should be the randomness component of focus. Bad information leads to “vapor assets” that fail real world stress tests.

    Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift. Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?

    Every boom creates vapor assets once the low-hanging fruit is picked. Collateralized debt obligations (CDOs) and credit derivative swaps were the subprime boom’s vapor assets where NINJA mortgagors were given property rights in order to enable questionable securitizations at even more questionable AAA-ratings prices to take place. But when the bubble burst, “questionable” became “improbable” as deterministic metrics lacked robustness to manage uncertain investments.

    If the world were as deterministic as this blog suggests, then a 50:1 leverage ratio would suffice given the governance knowledge at hand. The fact that it doesn’t suggests that the true capital requirements does not become manifest until confronted with the uncertainty of the “Minsky Moment.” Unless the problem is properly defined (risk vs. uncertainty as to asset categorization), you are merely trading errors of commission (AAA CDOs) for errors of omissions (stag-flation).

  40. Because people did the math and there is a dollar amount that is too low to put in a bank – the fees extract all of it in an ever shorter timeframe now…go figure, huh?

    And I was giggling too much while writing the chaos police quip and hit send before I filled in the name section – so thanks for the compliment that I am such an original personality, no name is needed – “Annie” is like “Pink”? It just IS?

    LOL

    BTW, I know lots of important people in “low” places – was allowed a peek at my WHC (Watch Her Closely) file – not much in there, but a “realist” has been assigned to evaluate another realist – all it says is, “Don’t call her stupid, you’ll live to regret it. Only danger for radicalization is if she hooks up with an activist “Save the Honey Bees” cult”.

    What’s in your file, mollyrose? Want me to try and get you a peek…?