Stress Tests: It Might Have Been Different If Fed Had Restricted Bank Dividends

Citigroup needs another $5 billion in capital according to stress test results leaked this week. But it might not have needed that money if it hadn't shelled out $7 billion in dividends to its shareholders last year.

According to a new study, Bank Dividends In The Crisis: A Failure Of Government, by finance professors at NYU's Stern School of Business, Princeton University and the London Business School, the largest US bailed out banks issued more than $50 billion in dividends even as their very existence remained in the balance. That total would have gone a long way in eliminating the $65 billion the banks now need in fresh capital as a result of the bank stress tests.

Dividend payments are important not just because they deplete capital, which the banks so desperately now need, but also because they can be a major source of compensation for company executives, as well as a boon for regular shareholders. Most bank executives are given a base salary, which is often relatively low, and stocks and bonuses. The dividend payments that come with the stocks--they are usually some set amount of money dolled out per share--can often boost overall compensation significantly.

From the end of 2007--when the Fed began injecting money into the banking system--through the fourth quarter of 2008 when the Fed instituted TARP, some of the largest banks continued to issue dividend payments to shareholders.

Once the Federal Reserve opened its balance sheets to the banks at the end of 2007, it was clear that there was an unprecedented banking crisis at hand, so regulators should have required the banks cut their dividend payments, the paper argues.

"The Federal Reserve should have made it a requirement that as soon as it became clear that the banks were in trouble, they stopped paying dividends," says Viral Acharya, a professor at NYU and an author of the study. While it might have spooked the market should individual banks have been signaled out by the Fed to cut their dividends, "an across the board rule for all the banks to cut these payments would have been totally acceptable."

At the end of 2007, Citi was paying shareholders a dividend of $0.54 cents per share, or $3 billion in total. During that same fourth quarter, the bank posted a 26% year-over-year decline in income.

During the first three quarters of 2008, as the Federal Reserve began rolling out more programs to provide cheap debts to the banks to ease credit and bolster lending, Citi paid out $0.32 per share, or a total of $6 billion in dividends.

In the fourth quarter of last year, when Citi partook of TARP funds, it halved its dividend payment to $0.16, or $1 billion, bringing its total dividend payout in 2008 to $7 billion.

It wasn't until the first quarter of this year that Citi finally cut the payment to a negligible $0.01 per share.

Bank of America reportedly needs $34 billion in fresh capital as a result of the government stress tests. At the end of 2007, BofA actually increased its dividend payments by more than 14% to $0.64, or about $3 billion. It continued paying that through the first three quarters of 2008, spending a total of roughly $15 billion on dividends from the third quarter of 2007 through the third quarter of last year.

In the fourth quarter of 2008, when BofA first received TARP funds, it cut the dividend payments in half, to $1.5 billion.

It wasn't until the first quarter of this year that the bank finally came close to eliminating its dividends, bringing it to $0.1 per share.

Some banks are emerging from the government stress tests without needing additional capital, such as Goldman Sachs and JP Morgan. While some of these banks, like Goldman, say they were forced to take bailout funds and would have been fine without the additional capital, it is hard to know the veracity of those statements because of the opacity of the banks' balance sheets.

In the case of Goldman Sachs, it has paid a dividend of $0.35 per share since 2006. It continues to make the payment despite the fact it has accessed TARP funds and issued millions of dollars in government-backed long-term debt.

JP Morgan, meanwhile, paid $0.38 per share, or roughly $1.35 billion every quarter throughout the crisis, and didn't cut its payments until the second quarter of this year.

It is also worth noting that the banks that have since collapsed were busy paying--and even increasing--their dividends up until the moment they failed.

Merrill Lynch increased its dividends by 91% in the last four months before it was swallowed up by Bank of America: In the fourth quarter of 2007 it paid out $381 million, but by the third quarter of 2008 that surged to $729 million.

Lehman Brothers, meanwhile, increased their dividend by nearly 100% before going bankrupt in September 2008. It paid out dividends totaling $103 million in the third quarter of 2007 and increased it to $204 million in the third quarter of 2008, weeks before going under. It also spent $100 million on a share repurchasing program.