Big Bank Dividends a Bad Idea

You can’t help thinking that the news media suffers from a very bad case of Attention Deficit Disorder these days. That is not really the fault of the reporters or editors, but is due to the incredible onslaught of events so far this year. One would have thought that the possible shutdown of the U.S. government, which has been operating under a series of stop-gap funding measures — each lasting only a couple of weeks — would find its way to the front page on a regular basis.

It was pushed off by a revolution in the largest Arab country in the world, and a major U.S. ally to boot. Fortunately, that revolution has be a pro-democratic and essentially pro-western one. What could push that out of the headlines? Well how about one of the largest earthquakes in recorded history hitting the world’s third largest economy. That earthquake spawned a Tsunami. Together the quake and Tsunami leveled a city of a million people (bigger than San Francisco).

You would think that would keep the world’s attention, except that the Tsunami also caused the worst nuclear disaster since Chernobyl. Surely that would stay the top story for a while. But no, the attention shifted back to North Africa, but not to Egypt. The UN Security Council approved a no-fly-zone over Libya to prevent its loony leader from slaughtering his own people who had risen up after over 40 years of his tyrannical rule.

That opens up a third major operating theater for the U.S. military. Even though the U.S. is not taking the lead — or plans to relinquish the lead — in the operations, it is still going to be a costly exercise. For example, in the early hours of the operation we fired off well over 100 Tomahawk cruise missiles, each with a seven figure price tag. That is not going to make progress on reducing the budget deficit any easier. It is also spending that is not going to pack much of a punch when it comes to helping out the economy.

Meanwhile, on Capitol Hill…

In such an environment, it is easy for things to slip under the radar. One of the most significant of these is the effort to effectively repeal the Dodd-Frank financial reforms by defunding any ability to implement them. This is happening less than three years after deregulation of the financial industry and a lack of desire on the part of the regulators to enforce the remaining regulations brought the world economy to its knees.

The budgets of the existing regulators such as the SEC have been slashed by the House. It remains to be seen if the Senate will go along, but if it doesn’t it substantially raises the odds of a shutdown of the Federal Government. No a great idea in my book when we are involved in three separate military operations.

A government shutdown would not help market confidence and would be extremely damaging to the economy. The attitude of the GOP on these matters was summed up by the new head of the House Financial Services Committee Spencer Bachus:

“In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks.” (see full story here)

We had more than eight years (the Clinton Administration was also very deregulatory when it came to the Financial Services industry) where the regulators were absolutely servile to the banking industry, and the result was a disaster that devastated the lives of millions and caused the worst recession since the Great Depression. Now the attitude in D.C. is as if that never happened.

The Dodd-Frank legislation was a small step in the right direction. If the Kaufman-Brown amendment had passed, it would have been a major step in the right direction. It would have limited the size of the biggest banks and gotten rid of the “too big to fail” problem.

The immediate response in the crisis was to make the “too big to fail” problem much, much worse as Wells Fargo (WFC) gobbled up Wachovia, J.P. Morgan (JPM) consumed what was left of Bear Stearns and Washington Mutual, and Bank of America (BAC) ate Countrywide and then Merrill Lynch. The reason for doing so was “any port in a storm,” but the long-run problem was made far worse.

However, even the extremely modest reforms that it made are being undermined. President Obama has not even yet nominated anyone to be the permanent head of the Consumer Financial Protection Bureau. The interim head, Elizabeth Warren, was the one who came up with the idea, and is ideally suited to the job, but she would face an uphill fight to get Senate confirmation (where 40 senators can block just about anything).

The banks do not like the idea of having to state the terms of the loans they make in clear, easy-to-understand terms. There is a reason why the riskiest loan products are peddled to the least sophisticated of consumers — because the banks can get away with it, and because those loans are very profitable to the banks.

During the debate over Dodd-Frank, it was argued by many that the best line of defense against another financial crisis would be to require banks to have more skin in the game. For their balance sheets to be less leveraged and to have more equity capital. Among those who were the most prominent advocates of that approach was Tim Geithner, the Treasury Secretary.

Dividends to Weaken Bank Balance Sheets

Now just a few months after the bill was passed, the government is taking steps that will substantially weaken the balance sheets of the banks, including the “too big to fail” banks that in another financial crisis would again be bailed out by the taxpayers.

How are they weakening bank balance sheets? By allowing them to increase their dividends dramatically and for them to buy back stock. Retaining your earnings is the quickest way to build up equity capital. Every dollar in dividends paid out is a dollar less equity on the balance sheet.

Of course, having less equity means a higher return on equity during good times. That will mean even bigger bonuses for the banking executives (not to mention that they tend to have a fair amount of bank stock, and will be thus getting bigger dividend checks). Big bonuses also deplete equity capital.

Meanwhile, in the wake of the crisis mark-to-market accounting was abandoned, and the banks were allowed to value their assets according to their own models (“mark-to-myth”). Thus investors can not really tell if the book value of the major banks belongs on the fiction or non-fiction shelf.

I have no doubt that the value of most of those “toxic assets” has increased over the last two years, and that the banks are probably much better capitalized now then they were then. Still, this does not seem the time to step back and let them go on a leveraging spree again; particularly by lowering the equity side. If they want more leverage, it would be much better for the economy if they started to lend more aggressively, particularly to small businesses.

…Fool Me Twice, Shame on Me

On the plus side, the higher dividends will help boost overall personal income, which might help increase overall demand in the short run. Doing so is dangerous in the extreme. We are setting ourselves up for another financial meltdown. We have taught the bankers that they are in a “tails they win, heads the taxpayer loses” situation.

The eight- and even occasional nine-figure bonuses that were “earned” on the basis of ephemeral and illusory “profits” before the crisis were never recouped, and no top level bankers have gone to jail as a result of it. Now we are going back to square one.

Allowing banks to once again pay out large dividends and handcuffing those who have the job of making sure that the banking system is safe and sound substantially hastens the day when we will face another large scale financial meltdown. I don’t think it will be this year or next, but it will happen, probably within the next decade.

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