Fed Shrugged Off Warnings, Let Banks Pay Shareholders Billions

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.”

Tarullo’s task

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.”

The first stress test

At the Fed,
battle lines over how rigorously to regulate banks were drawn during the first
stress test. Officially known as the Supervisory Capital Assessment Program
(SCAP, pronounced “Ess-Cap”), the first stress test
certainly forced most banks to beef up their capital. But even coming right out
of the gravest economic peril since the Great Depression, the Fed gave the
banks concessions.

When it
first began to test banks against bleak economic scenarios, the Fed took a
conservative stance toward bank plans for the future. If a bank was going to
sell a business line or other asset to raise capital, it had to complete the
transaction before the Fed would count it toward fulfilling the bank’s new
capital requirements.

One debate
was over what are known as “deferred tax assets” — losses that can be
written off against future profits. If a bank suffers losses for a prolonged
period, it can lose the opportunity to take the write-off, and the asset
becomes worthless. Initially, some supervisors pushed for a conservative
treatment. Capital is supposed to absorb losses in a crisis. Deferred tax
assets, or DTAs, can’t do that because they are little more than an accounting
concept.

For the stress
test, the Fed assumed that banks’ profits would suffer a prolonged hit in an
economic downturn, reducing or wiping out the value of these assets. But there
was an issue with Wells Fargo. Since it hadn’t lost money even at the depths of
the 2008 crisis, should it be able to get some credit for its deferred tax
assets?

Janet Yellen, then-president of the Federal Reserve Bank of San
Francisco, supported Wells Fargo. The tough-talking Tarullo
came around to her view, according to four people familiar with the
negotiation. At the end of 2009, banks were haggling over the details of how to
fulfill the capital-raising requirements. The Fed allowed Wells to get some credit
for its remaining deferred tax assets. The softer treatment set off cascading
effects: Supervisors had to scramble to give Pittsburgh-based PNC Bank similar
credit because it, too, had weathered the crisis better than other banks and
had a large portion of deferred tax assets on its balance sheet.

“It is
common — perhaps too common — for reserve presidents to tend to
believe that their firms are invariably better than average,” laments a former
Fed governor.

“The
treatment of Wells’ DTAs was fully consistent with a rigorous” stress test,
says Yellen, now vice chair of the Fed board of governors,
in a statement. She argues that a key issue was that the tax write-offs were
imminent, so the risk was minimal that Wells would suffer losses and not be
able to use them. “Under Federal Reserve capital regulations, it is appropriate
to count DTAs as capital when they are going to be realized in the very near
term,” she says in her statement. “After looking at the specific
characteristics of Wells’ DTAs, senior Board staff determined that they
qualified as capital” for the first stress test.

PNC and
Wells declined to comment.

In a speech
on May 6, 2010, the one-year anniversary of the tests, Fed Chairman Bernanke called
the
first stress test a “watershed event,” crediting it with having helped
“restore confidence in the banking system and the broader financial system,
thereby contributing to the economy’s recovery.”

By the third
quarter of 2011, the top 19 banks that underwent the tests had added hundreds
of billions in capital. A crucial measure of their capital is known as Tier 1,
and it consists mostly of common stock, reserves and “retained earnings”
— income that is not paid to shareholders but instead kept by the company
to invest in the business. By the end of the third quarter, the top banks’ Tier
1 capital was up to about $740 billion. Using an average weighted to account
for the different sizes of the banks, that’s 10.1 percent of their assets,
compared with a low of 5.4 percent at the end of 2008.

As the banks
built more capital, struggles erupted among various government bodies about
when and how to let banks pay back TARP money. Most of the banks wanted to pay
back the government as quickly as possible, mainly because the bailout money
came with intensified oversight and potential restrictions on how much
executives could pay themselves. And with the bailouts deeply unpopular with
the public, the Treasury also pushed for the banks to pay back the money as
quickly as possible so the government could claim the program was successful
and hadn’t cost the taxpayers much.

But how
should the banks replace the taxpayer money? Could they borrow to pull together
the money, or should they be required to raise what’s known as common equity,
the basic type of stock, whose holders absorb the first losses in the event of
problems? Doing the latter would force banks to do the hard work of finding
investors and amassing solid capital that could cushion them against economic
blows.

The Fed led
the process to answer this crucial question, with contributions from the FDIC,
the Treasury and another major bank regulator, the Office of the Comptroller of
the Currency (OCC).

In late
2009, regulators decided that the eight financial institutions that hadn’t
exited TARP immediately after the first stress test, including Bank of America,
Wells Fargo and Citigroup, would be able to pay back every $2 of TARP money by
issuing $1 in new common equity, according to a Sept. 29, 2011, report by the
special inspector general of TARP. The banks could raise the other dollars
through other ways, such as borrowing.

Yet, almost
as soon as they had decided on that standard, the Federal Reserve and OCC
relaxed it for some of the most troubled big banks. The FDIC “was by far the
most persistent in insisting that banks raise more common stock,” the report
found.

The FDIC
pushed repeatedly for the banks to adhere to the guidance known as the
“2-for-1” provision.

Sheila
Bair’s agency was particularly frustrated when the Fed and OCC eased their
conditions for Bank of America, one of the most vulnerable banks.

Bair told
the TARP special inspector general that “the argument [the Fed and OCC] used
against us — which frustrated me to no end — is that [Bank of
America] can’t use the 2-for-1 because they are not strong enough to raise
2-for-1.” She said: “If they are not strong enough, they shouldn’t have been
exiting TARP.”

The Fed
decided it could ignore the FDIC’s views. On Nov. 19, 2009, an unnamed Federal
Reserve governor stated that Bernanke’s position was that “we would go ahead
without [FDIC] agreeing,” according to a previously unreported email from a
draft version of the special inspector general’s report. And indeed, Bank of
America fell more than $3 billion short of 2-for-1, raising $19.3 billion in equity
to pay off the taxpayers’ $45 billion.

Since then,
Bank of America has run into further troubles and been forced to sell assets
and raise capital.

The Fed has
taken pains to hide such tussles and compromises. The email describing
Bernanke’s decision to override the FDIC, along with many others, was excised
from the final draft of the special inspector general’s report. In a footnote
in the final, published report, the special inspector general wrote that the
Federal Reserve “strenuously objected to the inclusion of a significant amount
of text” in earlier versions of the report, citing the need to keep
communications with banks confidential.

Even though
the special inspector general wrote that she “respectfully disagrees” with the
Fed, she allowed the emails to be excised from the published report.

Stresses during the stress test

In 2010, as
the Fed began the second stress test, officially known as the Comprehensive
Capital Analysis and Review (CCAR, pronounced “See-Car”), bankers lobbied
heavily to be allowed to return capital to shareholders. They began to feel
emboldened to speak out against tightening regulations.

In late
2010, Tarullo had at least two conversations about
capital planning, not previously reported, with top bank CEOs: JPMorgan’s Jamie
Dimon and Citigroup’s Vikram
Pandit. Dimon pressed Tarullo about the Fed’s plans for how much capital large
banks should be required to have. The JPMorgan CEO, who has been an outspoken
critic of the post-crisis regulatory tightening, argued to Tarullo
that “it made sense to differentiate between banks,” says a person familiar
with the discussion. “If we were healthy, we should be allowed to pay dividends
and buy back stock.”

Bank
executives such as Dimon and Pandit
stood to gain personally from dividend decisions since much of their
compensation comes in the form of stock.

Tarullo
says he and the Fed were not unduly influenced by Dimon,
Pandit and others who lobbied on behalf of the banks.

Inside the
Fed, whether to pay dividends had been hotly debated for years. Less than a
year after the height of the crisis, in August 2009, top officials from around
the system met with Tarullo in Washington, where they
mulled letting banks return capital to shareholders. Some Fed officials were
shocked that the regulators were considering returning dividends so soon,
according to one attendee.

Margaret
“Meg” McConnell, a wiry and intense macroeconomist from the New York Fed,
raised the possibility that the Fed might bar even healthy banks from paying
dividends, if the regulator thought the environment was still too fragile. This
is dubbed a “macroprudential” approach. Generally
mild-mannered, McConnell surprised people with her emotion. She spoke “with a
bit of pique,” a person at the meeting recalls.

But other
Fed officials at the meeting argued that could be dangerous because it would
erode investor confidence. They feared such an action might inadvertently
signal that the Fed was still worried about the financial system. Preventing
even ostensibly healthy banks from returning capital for a period of time might
be destabilizing in and of itself. Investors could get the wrong idea and
panic.

There were
other debates. The European crisis, while not as acute as it would become in
2011, was clearly brewing by the time the stress test began in late 2010. Some
supervisors argued that the test should include an evaluation of the banks
against some European measure, such as a stock-market index, and make it
public. In the end, that was rejected. The Fed worried about creating political
backlash by suggesting Europe was in deep trouble, according to a person
familiar with the discussion.

“It was
important for us to create a regular, annual process to ensure that banks could
only increase dividends or buy back shares if they could show they would remain
healthy even in the face of adverse economic conditions,” Tarullo says to ProPublica. “It’s not reasonable to say
that a bank could never return capital to its shareholders, no matter how
well-capitalized it has become, but it is reasonable to require that any such
action be premised on a sound capital plan and rigorous stress testing.”

The Fed’s
legal department acted as a brake on aggressive supervisors. The department,
headed by the powerful general counsel, Scott Alvarez, had long served as a de
facto overseer of supervision in Washington. The board of governors often asked
Alvarez to report on various supervisory topics.

Tarullo
appeared frustrated by this back-channel reporting and tried to curtail it,
according to people familiar with the workings of the board of governors. He
clashed with the legal department, viewing it as too friendly to the banks.

As
supervisors conducted the second stress test, the legal department assessed
whether the Fed had the authority to stop banks from raising their dividends
— a move that surprised some supervisors because the banks themselves had
never raised such an objection to the Fed’s power. After all, the Fed has
statutory responsibility to maintain the “safety and soundness” of banks. Some
staffers interpreted the legal department’s action as a sign that the Fed was
looking for ways to hamstring itself, a signal that they should tread lightly
when it came to restricting banks from returning capital to shareholders.

The Fed
declined to comment and didn’t make Alvarez available.

Once
Dodd-Frank was passed in the summer of 2010, making bank supervision a more
vital part of the Fed’s mandate, the board of governors wanted to monitor Tarullo’s efforts, so the board requested regular briefings.
One governor, Kevin Warsh, a George W. Bush
appointee, viewed the Fed’s overall bank regulatory approach skeptically.
Something of a libertarian, he thought that the Fed was overly confident in its
abilities to monitor banking activities and head off crises before they became
acute.

But Warsh, who oversaw financial market activities and not
regulation and supervision, also worried that the banking system had too little
capital. Do the banks have enough to offset losses? Do their books accurately
value their assets? Do they have the proper risk management systems in place?
he worried to colleagues. “There is too much confidence that these institutions
won’t find themselves in the soup again,” Warsh tells
ProPublica.

But the Fed
had boxed itself in with its standard: The regulator had told the banks that if
they hit their capital requirements under the stress-test scenarios, they could
pay dividends and buy back stock.

Ultimately,
the Fed did not allow every bank to increase dividends. Some banks, like Citigroup,
didn’t request an increase after a signal from the Fed that it would be turned
down.

In at least
one instance, a signal was misinterpreted. Early in the process, the Richmond
Fed left Bank of America with the impression that it would pass the stress test
and be allowed to raise dividends. Encouraged, the bank asked permission.

In late
2010, Chief Executive Brian Moynihan suggested to investors that a raise would
come in the second half of 2011. But in the end, the Fed nixed any dividend
raise. The Fed and Bank of America declined
to comment on this incident.

A triumph
for Tarullo, the episode nevertheless harmed investor
confidence in Bank of America and its management, becoming one of the more
embarrassing in Moynihan’s tenure at the bank.

The FDIC vs. the Fed

To some
regulators, the second stress test seemed like little more than a formality
with officials inclined from the outset to allow most banks to return money to
investors.

“Institutionally,
the decision was already made” before it was completed, says a former senior
regulator who was involved in the testing. A Fed spokeswoman says that was not
true.

Still, when
a senior regulator familiar with the FDIC’s thinking heard that the Fed was
considering allowing banks to return capital to shareholders, “my first
reaction was: You’ve got to be kidding me. We are still in the middle of the
crisis,” the official recalls. “We believed the banks didn’t have the structure
for capital distribution, for dividends and stock buy-backs.” The stress tests “continued
to get better, but they were not picking up the full gamut of risks.”

The banks
had portfolios of underwater mortgages, and growing legal problems stemming
from their pre-crisis actions and post-crisis foreclosure practices. Given the
ongoing uncertainty about the global economy and the fragility of the world’s
financial system, FDIC officials repeatedly voiced concerns to their Fed
counterparts.

As the Fed
began the test, Bair wrote her Nov. 5, 2010, letter to Bernanke. “We would
prefer to see a longer period of stability, sustained core earnings growth, and
strengthening of capital buffers before dividends are considered,” she wrote.

The letter
pointed out that “once the level of dividends increases, it is difficult to
scale back.”

One major
concern was accurately measuring legal liabilities. Banks that had assembled
mortgage-backed securities often faced accusations of fraud or deception from
investors in those securities. Now, the banks faced a threat that courts would
force the banks to take back billions of dollars’ worth of toxic mortgages,
known as “put-back” risk. With input from the legal department, the Fed had
come up with a system-wide estimate for this risk that the FDIC considered too
low, according to two people familiar with the process.

Worse, by
the fall of 2010, banks had an emerging legal threat to worry about:
foreclosure problems. In the aftermath of the housing crash, banks had abused
the rights of homeowners in the process of foreclosing. The most publicized
issue was “robo-signing,” in which banks had
documents automatically notarized by people who weren’t reading the materials
or checking for inaccuracies. As this threat emerged, banks came under
investigation by state attorneys general and faced billions in new potential legal
liabilities.

“The highly
publicized mortgage foreclosure process flaws provide an example of how quickly
material issues can arise in these institutions and how they are still exposed
to the poor decisions made in the years leading up to the crisis,” Bair warned
Bernanke in her letter.

Estimating
these future liabilities was a task the Fed delegated mainly to the banks. In a
Dec. 12, 2010, speech, Tarullo said the Fed expected
“that firms will have a sound estimate of any significant risks that may not be
captured by the stress testing, such as potential mortgage put-back exposures,
and the capacity to absorb any consequent losses.”

But the
various foreclosure problems were just emerging, so estimating those
liabilities was difficult — though it was clear that they could be huge.

The FDIC was
puzzled. “The direct connection between the put-back issue and the stress test
never has been clear to me. They didn’t take the number and add it to the
bottom line,” says the senior regulator familiar with the FDIC’s position.
“They didn’t have any sizing on broader servicing liabilities.”

All the more
reason, FDIC officials thought, to slow down the dividend payouts and stock
buy-backs.

The Fed did
have an effort parallel to the stress test to assess these liabilities, and, according
to a Fed spokeswoman, eventually included the legal risks in the stress test.

(In
February, banks settled robo-signing problems with
state attorneys general for $25 billion but remain on the hook for other legal
liabilities arising from their mortgage servicing.)

By March
2011, it was clear the FDIC had lost its argument. The stress test was winding
up, and most of the big banks would get a green light. The agency made a last
stand on one bank: SunTrust, a large regional bank based in Atlanta.

The Fed had
determined that SunTrust passed the stress test and could exit TARP. Bair
appealed to Tarullo, according to several people
familiar with the matter. The objection has not previously been reported.

The FDIC
didn’t think SunTrust was ready to pay back the government and leave the
program. It was one of the last big banks to still have TARP money. It was
loaded with high-risk assets, such as interest-only, adjustable-rate mortgages
and loans to borrowers with low credit scores.

But the Fed
shunted aside Bair’s appeal and allowed the bank not only to repay the
government but to do so on indulgent terms that the FDIC thought left SunTrust still
vulnerable. When it green-lighted SunTrust’s exit, the Fed didn’t adhere to the
2-for-1 replacement standard regulators had established for healthy banks. The
bank issued only $1 billion in new common stock to repay the government’s $4.85
billion in preferred stock.

The FDIC had
lost again.

Two former
Fed officials who held senior posts during the crucial decision-making say they
were troubled, believing that SunTrust didn’t have enough capital. “I was
horrified,” says one of the officials.

Since then,
investor views have mirrored those of the Fed’s critics. In 2011, SunTrust
shares tumbled more than 41 percent. The bank has a market value of about half
of the value of the assets on its balance sheet — a sign that investors
suspect the bank is overstating the worth of its assets and exaggerating its
overall health.

SunTrust and
the Fed declined to comment.

Looking ahead

Some see
allowing dividends and stock repurchases as a confidence-building exercise. The
hope is that investors will believe that the Federal Reserve is confident in
the banks and will buy bank stocks. Higher share prices mean that banks can
sell stock more cheaply if necessary. The regulators’ logic seems to have been:
Let the banks deplete capital to raise capital.

In the
second stress test, “how much was appearance, and how much was reality? The Fed
wanted the appearance of strength,” says a former senior regulator. “The Fed
wanted everyone to see that the banks were profitable, back to normal and back
on the road to health. … And the banks wanted it.”

Passing the
banks makes the Fed look good, too. The Fed “wanted it as a symbol of their
success in mending the banks,” the senior regulator says.

Tarullo
strongly defends the decision to allow some of the banks to return capital to
shareholders.

“If you
imagine a truly severe financial dislocation, it’s not going to matter much for
the health of the U.S financial system whether banks paid out five or eight
percentage points more of earnings in the preceding year,” he says. “What
will matter is that the banks have been steadily building capital to much
higher levels than existed before the financial crisis and that they are
subject to annual stress tests to make sure they have the capital needed to
withstand a quite adverse economic situation.”

Indeed, the
Federal Reserve is at it again, conducting another stress test of the biggest
banks. The Fed is testing the banks against much more dire scenarios than it
did a year ago, which some analysts see as an implicit admission that it was
too soft in the earlier test. This time, in order to comply with Dodd-Frank,
the Fed must make much greater disclosure of how the
tests are conducted and which banks pass.

The
tests are draconian. They require the banks to plan against a scenario in
which, among other drastic occurrences, the Dow Jones Total Market Index crashes to 5,668 and gross domestic product falls four quarters in a row,
including one 8 percent quarterly drop, almost as much as it did in the fourth
quarter of 2008, and unemployment rises to more than 13 percent. Can any of the
banks truly survive such a scenario? And will the weaker ones be restricted
from buying back stock or paying dividends?

The Fed
seems to have put itself in a bind. Either the banks don’t pass, which could
harm investor optimism and thus the fragile economic recovery. Or the banks
somehow do pass, risking the Fed’s credibility in the event of another crisis.

The results
will be out in mid-March.

Correction: A previous version of this story incorrectly dated the letter from Anat Admati to the Financial Times. The letter was published in February 2011. It also misstated the name of a stock index the Fed is using in its new stress test, scheduled to be completed this month. A scenario the Fed is using involves the Dow Jones Total Market Index crashing to 5,668, not the Dow Jones Industrial Average.