One year ago, the largest financial institutions on Wall Street were desperate to show off their strength by paying out, or raising, dividends for the first time since the Great Recession. After conducting a secretive test of the banks' health, the Federal Reserve granted most of their requests in March 2011 -- over loud objections from economic luminaries in Washington and across the country. Now, for the first time, we tell the story of why the Federal Reserve caved, and how Wall Street still owns the place.
In early November 2010, as the Federal Reserve began to weigh whether the nation's biggest financial firms were healthy enough to return money to their shareholders, a top regulator bluntly warned: Don't let them.
"We remain concerned over their ability to withstand stress in an uncertain economic environment," wrote Sheila Bair, the head of the Federal Deposit Insurance Corp., in a previously unreported letter obtained by ProPublica.
The letter came as the Fed was launching a "stress test" to decide whether the biggest U.S. financial firms could pay out dividends and buy back their shares instead of putting aside that money as capital. It was one of the central bank's most critical oversight decisions in the wake of the financial crisis.
"We strongly encourage" that the Fed "delay any dividends or compensation increases until they can show" that their earnings are strong and their assets sound, she wrote. Given the continued uncertainty in the markets, "we do not believe it is the right time to allow transactions that will weaken their capital and liquidity positions."
Four months later, the Federal Reserve rejected Bair's appeal.
In March 2011, the Federal Reserve green-lighted most of the top 19 financial institutions to deliver tens of billions of dollars to shareholders, including many of their own top executives. The 19 paid out $33 billion in the first nine months of 2011 in dividends and stock buy-backs.
That $33 billion is money that the banks don't have to cushion themselves -- and the broader financial system -- should the euro crisis cause a new recession, tensions with Iran flare into war and disrupt the oil supply, or another crisis emerge.
This is the first in-depth account of the Fed's momentous decision and the fractious battles that led to it. It is based on dozens of interviews, most with people who spoke on condition of anonymity, and on documents, some of which have never been made public. By examining the decision, this account also sheds light on the inner workings of one of the most powerful but secretive economic institutions in the world.
The Federal Reserve contends it assessed the health of the banks rigorously and made the right decisions. The central bank says the primary purpose of the stress test was to assess the banks' ability to plan for their capital needs. The Fed allowed only the healthiest banks to return capital -- and they are still not paying anything like the proportion of profits that they distributed in the boom years. And it says the stress test covered only one year. Regulators say they can revisit their decisions if the economic picture turns bleaker.
Most important, Fed officials argue that the biggest financial institutions still added $52 billion in capital to their balance sheets in 2011 despite raising dividends or buying back stock. The top 19 financial firms had a 10.1 percent capital ratio by the end of the third quarter of 2011, using the measure that regulators primarily look at, nearly double what they had in the first quarter of 2009.
But a wide range of current and former Federal Reserve officials, other banking regulators and experts either criticized the decision to allow dividend payments and stock buy-backs then, or consider it a mistake now.
Among their reasons: Allowing banks to return capital to shareholders weakened American banks' ability to withstand a major shock. Whether they are too weak remains debated, but dividends and buy-backs matter. From 2006 through 2008, the top 19 banks paid $131 billion in dividends to shareholders, according to SNL Financial. When the financial crisis hit, the banks were weak in large part because they didn't have those billions. Indeed, in the fall of 2008, the government invested about $160 billion in the top banks.
Today, the European economic and banking crisis, which was looming when the Fed made its decision, continues to threaten the economy. Unemployment in the U.S. remains persistently high, and the housing market fell almost 5 percent last year, according to CoreLogic, a financial information firm.
American banks are suffering metastasizing liabilities from the U.S. foreclosure crisis. A recent settlement with almost all states' attorneys general covered only part of those costs, leaving many banks bleeding cash to cover legal costs of the robo-signing scandal and other problems related to the housing crisis.
Once banks start paying dividends, it's difficult for a regulator to get them to stop without panicking investors. Indeed, building investor confidence was one reason the Fed allowed dividends. But by that measure, it failed: This past November, ratings agency Standard & Poor's downgraded most of the biggest American banks, and financial stocks in the S&P 500 plummeted more than 18 percent in 2011, though they have since bounced back a little.
Many banks are trading below "book value," meaning the value of their stock is less than what the banks say are the value of their assets. This fact is particularly sobering, because it suggests investors do not trust the banks' accounting and are skeptical of their future profitability.
Eventually, the banks will have to raise capital to comply with new international standards, to be in place fully by 2019. The Fed's decision leaves them further from that goal than they would be otherwise.
But the Fed's stress-test decision was lucrative for shareholders and bank executives, who are increasingly paid in stock. Dividend payments are taxed at lower rates than ordinary income. Merely allowing the banks to pay dividends, buy back stock and pay back the government helped boost shares, albeit temporarily.
"As undercapitalized as many of these banks are, allowing them to return capital, in my opinion, is preposterous. I can't believe a strenuous stress testing of their mortgage assets, European exposures and other questionable assets would allow them to return capital to shareholders," says Neil Barofsky, who until March 2011 served as the special inspector general for the Troubled Asset Relief Program (TARP), better known as the bailout.
"Taxpayers should be concerned when banks pay dividends and remain thinly capitalized," warned Anat Admati, a finance professor at Stanford in a February 2011* letter to The Financial Times signed by 15 other economists from across the political spectrum. "Taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis."
WHAT WAS THE FED THINKING?
The Fed's decision cannot be understood in isolation. It continued a series of actions -- by the central bank and other arms of government -- that were generous to the banks. When the government invested hundreds of billions in the banks through TARP, banks didn't even have to lend out the money, and bankers could pay themselves bonuses. To keep the financial system from collapsing, the Federal Reserve provided more than $1 trillion to the banks in low-interest loans and loan programs, which were highly profitable for the recipients.
Also, the dividend decision came as the Fed was painfully reinventing its regulatory role after being blindsided by the worst economic crisis since the 1930s.
One of the world's most powerful economic institutions, the Federal Reserve sets interest rates, controlling the supply of money to stimulate the economy and prevent it from overheating. The Fed also regulates American banks. Designed to be insulated from political tussles, the central bank makes its decisions independently of the president and Congress. Its board of governors is appointed by the president, however, with Senate approval.
Chairman Bernanke has promised the Fed will be more open and transparent, but it still conducts much of its bank regulation and supervision behind closed doors on the grounds that disclosures about individual institutions could cause bank runs and financial panics.
Before the financial crisis, bank oversight had long been a backwater at the Fed, especially under former chairman Alan Greenspan, who advocated for deregulation. The glory and promotions within the Fed lay in monetary policy -- deciding what level to target for interest rates and preventing inflation or high unemployment. Indeed, before 2008, the Fed's bank regulation and supervision had been disastrous, failing to prevent or foresee multiple financial crises, including the near-collapse of the entire financial system in 2008.
In the wake of that terrifying experience, the Fed decided it needed to determine just how strong the banks were and whether they could survive another economic shock. So, in early 2009, it carried out the first stress test, a system-wide assessment of how banks would fare under bleak economic scenarios. Following that test, in May 2009, regulators determined that the weakest 10 of the 19 banks needed to add $185 billion in capital by the end of 2010. They named those banks and announced key findings.
The second stress test, conducted from November 2010 through March 2011, is what led the Fed to allow banks to disperse capital to shareholders. And that test differed starkly from the first.
For starters, it was secretive even by the Fed's standards and certainly by comparison to the first stress test. To this day, the Fed has disclosed little detail about how the second stress test was conducted, and virtually nothing about how it decided which banks could release capital. Unlike its actions in the first stress test, the Fed hasn't released its estimates of banks' revenues, post-stress capital ratios or losses for asset classes, such as real estate. It did not even announce which banks passed the test.
Instead, the Fed left it to the financial institutions to disclose the results. In March 2011, 11 of the 19 announced that they had been given the go-ahead to buy back shares, pay dividends or get out of TARP. In the first three quarters of 2011, all 19 paid some dividends on either common or preferred stock, and 10 bought back some stock -- a total of $33 billion in common and preferred dividends and share buy-backs in the period, according to SNL Financial. That amounted to almost 5 percent of the most important, bedrock type of bank capital held by the 19 institutions as of the end of the third quarter.
But beyond the specifics, the political climate had also shifted by the time of the second stress test. Bankers were emerging from their defensive crouch, emboldened to push back against what they considered excessive regulation. At the same time, the sweeping 2010 financial reform act known as Dodd-Frank gave the Federal Reserve more supervision responsibility. What the Fed had done in a panic in the aftermath of the 2008 crisis was now codified as one of its central legal duties, and as it tried to adapt to its new mission, it suffered internecine battles.
Responsibility for overhauling and improving the Fed's bank regulatory efforts rests with Daniel Tarullo, a 59-year-old former Clinton administration official and academic who became a governor in January 2009. Bankers utter his name in hushed and embittered tones, terrified of his aggressive calls for more oversight and capital. With his white hair and square jaw, he recalls a pro football linebacker from a previous era. Yet, his actions have often fallen short of his tough talk, critics say.
He oversees a sprawling, fragmented institution. Twelve regional reserve banks share bank oversight responsibility with the central board of governors, based in Washington, D.C. The reserve banks have historically taken most of the bank supervision responsibilities, while Washington has concentrated on monetary policy. The individual reserve banks are frenemies, sometimes working together but often suspicious of others' motives and jealous of each other's clout.
"It's like 'Survivor': You make certain alliances, but that doesn't mean you won't cut the throat of the person the next time," says a former Fed supervisor.
The most powerful of the regional banks, the Federal Reserve Bank of New York, rivals the central board in authority and influence. The two institutions often butt heads. The New York Fed is widely seen throughout the rest of the system as overly protective of the two biggest institutions it supervises, JPMorgan Chase and Citigroup. New York returns the view, believing the Richmond Fed to be captured by the biggest bank it oversees, Bank of America, and San Francisco by its charge, Wells Fargo.
Bank supervisors, especially the ones deployed to work physically inside the banks that they oversee, are, like all regulators, vulnerable to capture by the institutions they police. They sometimes identify with and coddle their banks rather than enforce the rules, according to multiple current and former Fed officials.
"You have to work with these people every day. You develop working relationships," says a New York Fed official. "You have to put yourself in their shoes, but you have to make sure they are safe and sound."
Given what its critics call its supervisory neglect, regulatory capture and bureaucratic rivalries, the Fed had a poor understanding of the sector it regulated in the lead-up to the 2008 crisis. "If a supervisor wanted to see [the Fed's] systems, he would have flunked us miserably," recalls a former Federal Reserve banking official. "We would joke about that a lot."
Mandated to overhaul this system, Tarullo centralized supervision -- and thus power -- in Washington.
"As an academic, I think I came to have a pretty good understanding of the substance of the Fed's regulatory policies," Tarullo tells ProPublica. "But when I got here, I was surprised that the large institution supervisory process wasn't very well coordinated across firms, and really didn't draw on all the economic expertise of the Federal Reserve."
When he arrived, Tarullo found that the supervision and regulation division was beset by personal disagreements and turf battles. He found the unique structure of the Federal Reserve complicated bank supervision and regulation, and such problems persist.
"That's why we created the Large Institution Supervision Coordinating Committee -- to make strong coordination and interdisciplinary perspectives permanent features of the supervisory function," he says.
Part of that may be due to his management style. Universally regarded as smart, Tarullo doesn't always look people in the eye. He often leans back in his chair, tilts his head up and addresses the ceiling. The rank-and-file thought he mistrusted them and didn't listen, according to several former Fed employees.
Tarullo and some at the Fed defend his leadership, but critics say his manner could undermine his push for tighter regulation, especially with the Fed's old guard. "Our esteemed leader," was how Patrick Parkinson, a Greenspan acolyte who retired at the end of 2011 as the director of the division of banking supervision and regulation, sarcastically referred to Tarullo, according to a former Fed employee. Parkinson didn't return calls seeking comment.
Tarullo is known for his temper. He has made a few employees cry, according to people familiar with the incidents. At a meeting of the board of governors in late 2009, Tarullo blew up at Coryann Stefansson, a former supervisor who ran the first stress test in front of the entire board. As she contended that the Fed shouldn't push Bank of America to raise more capital, Tarullo surprised people in the stuffy Fed meeting rooms, laden with heavy, dark wood furniture, shouting: "How dare you interrupt me?" a person familiar with the meeting recalls.
Yet, Tarullo gave ground eventually on BofA. In the end, the Fed pushed Bank of America to raise more capital than it initially proposed but less than the FDIC wanted.
The Fed and Tarullo declined comment on the incident.
For his part, Tarullo is cautious about his accomplishments, saying, "I don't want to overstate how much progress has been made, but I do think that with the authority we either had already or have gained from Dodd-Frank, plus the creation of the [large institutions committee] and the requirement of regularized capital planning and oversight, there are at least the makings of something durable."