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.