How the Fed’s dividend daze could backfire

March 23, 2011, 2:36 PM UTC

It’s all gravy for the bankers now. But the rest of us could still get stuck cleaning up if the pot boils over.

The Federal Reserve gave many of the biggest U.S. banks the go-ahead Friday to boost dividends and expand share buybacks. JPMorgan Chase (JPM), Wells Fargo (WFC), Goldman Sachs (GS) and U.S. Bancorp (USB) quickly responded with plans to spend more than $26 billion this year on dividends and repurchases.

Dividend daze?

You might think the Fed could afford to err on the side of letting hapless bank shareholders cool their heels for a bit. After all, a new threat to the recovery seems to hit about every other week lately. And needless to say, no relief is in sight for small savers who have been bankrolling the banks’ bonus-filled rebound with near-zero deposit rates.

But as it often does, the Fed let the banks have their way – knowing full well that these mighty titans will continue to pose a threat should another economic storm front roll in.

While all the big banks have repaid their Troubled Asset Relief Program loans, they are still leaning on another, less visible, taxpayer crutch: the Federal Deposit Insurance Corp.’s crisis-era effort to thaw funding markets, known as the Temporary Liquidity Guarantee Program.

Together the big four dividend-boosting banks hold $62 billion of federally subsidized borrowings under the TLGP, according to data from Dealogic and SNL Financial. Altogether, some $261 billion of TLGP bonds will come due between now and the end of 2012.

While the economy looks to be healing and the markets have been stable, an FDIC official warned this month that it would be complacent to assume the banks can pay off shareholders without potentially stretching the capital cushions that gave out so magnificently during the financial crisis.

“The regulators should not approve dividend and capital repurchases, which involve significant cash outlays by financial firms, until we are all fully confident that these firms will have the financial resources ─ under both normal and stressed conditions ─ to repay debt guaranteed by the FDIC,” the FDIC’s Jason Cave told the Congressional Oversight Panel March 4.

The FDIC’s caution is understandable because of the risks it is taking in backing the bonds. Citigroup (C), for instance, has the most FDIC-backed debt outstanding (see chart, right), with $58 billion. It isn’t sharply raising its dividend and says it won’t need to borrow new money to replace the maturing debt. Still, questions about its fitness in a downturn remain.

You might also raise an eyebrow at the No. 2 FDIC borrower, General Electric (GE). It wasn’t included in the latest Fed stress test but has raised its dividend 40% over the past year and now pays out $6 billion annually.

If the Fed is worried about the concentration of risk on the FDIC’s books, its stress test statement didn’t show it. It said only that the central bank “consulted” with the FDIC and other regulators.

Perhaps that’s because for now, there is no great fear that the loans won’t be repaid. Interest rates are low and high-quality borrowers have had little trouble tapping debt markets. Morgan Stanley (MS), which wasn’t among Friday’s dividend hikers, sold $5 billion of bonds in January.

What’s more, the FDIC so far hasn’t lost a dime since the program started in October 2008, while guaranteeing as much as $345 billion worth of debt. It raked in $10 billion in fees while issuance continued through 2009. The agency has said it would add those funds to its underwater deposit insurance fund if program fees exceed losses, as it expects.

So chances are that nothing untoward will happen. And of course, the Fed does deserve credit for drawing the line with Bank of America (BAC), which continues to be in denial regarding its financial health.

Even so, it’s hard to ignore the thought that the Fed may not be stressed enough about an outcome that Cave pointed to — that debt markets can turn on a dime, as they did in 2007 en route to the 2008 meltdown.

“While no one knows for certain what is in store for the credit markets in late 2011 or 2012, we want firms to be more prepared for the possibility that rates could increase or credit become restricted at the very point in which significant amounts of TLGP debt comes due,” he said.

Sad to say, we won’t know whether the banks are actually doing anything to that effect till it’s too late.

Also on

Follow me on Twitter @ColinCBarr.