Should bank dividends be banned?

New appointee Jeremy Stein says yes:

Simply put, the government should force the banks to suspend all dividend payments," he told The Wall Street Journal in October.  "It makes absolutely no sense for the government to put money into the banks, only to see a significant fraction of it flow out again as dividends to shareholders, and in many cases, bank executives with large equity stakes."

I haven't seen much discussion of this issue.  Dividends are in general poorly understood by economists, in part because they continue to be paid when they face a significant tax disadvantage.  Surely there are cheaper ways to signal the quality of the firm.  One way of thinking about dividends is as a way to take advantage of bondholders.  Start a new firm, borrow $50, issue $50 in equity, and on day one pay $100 in dividends and by 4 p.m. declare bankruptcy.  Not a bad business model but of course neither the government nor the bondholders will let you.  This same strategy is also a way to take advantage of government subsidies and recapitalizations, even if you can't get the dividend up to one hundred percent.  So yes, I do see a case for following Stein's suggestion, at least for banks receiving government assistance above some threshold measure.

Stein, by the way, also favors this:

He advocated aggressive government audits of banks, aimed at separating
solvent ones from insolvent ones. Once that was done, insolvent banks
would be forced into closure or sale while solvent ones would be pushed
to raise more private capital. In addition to dealing with the bad bank
problem, putting the plan in place would remove much of the uncertainty
in financial markets that the government’s ad hoc approach to banks
thus far has helped instill.


And so it goes.... The government forces every major bank to take bailout money so as to not "stigmatize" any individual bank. Then, they use that investment as an excuse to make the equity of these banks as unattractive to private investors as possible. This leads to falling bank prices which requires further infusions of bailout money until we have a nationalized bank system.

A form of crowding out that I had never thought about until this past year.

"He advocated aggressive government audits of banks, aimed at separating solvent ones from
insolvent ones. Once that was done, insolvent banks would be forced into closure or sale
while solvent ones would be pushed to raise more private capital."

First thing, audits don't determine solvency-they merely state whether or not the financials
are fairly stated in conformity with GAAP. Examinations of financial condition determine solvency.

Second thing-if the bank management was unable to determine that parts of their portfolio will
blow up-bank regulators will be even less likely to determine it. By the time they pronounce death
rigor mortis is setting in..

"He advocated aggressive government audits of banks, aimed at separating solvent ones from insolvent ones. Once that was done, insolvent banks would be forced into closure or sale while solvent ones would be pushed to raise more private capital."

Isn't this exactly what would have happened in the absence of the $800 billion TARP?


Therefore, the only rational answer to this mess is to:

1. Defang the CDS monster. This must be done now. CDS provide a limited-risk and near-unlimited reward for shorting a firm's credit; this is exactly backwards from the equity markets where shorting is limited-reward but unlimited risk. Short-selling is essential to a balanced market but allowing CDS to be abused to invert the long/short risk profile is outrageous and must be stopped. The proper approach to doing this is to:
A. Force capital adequacy to be proved for all outstanding contracts. If you can't prove the ability to cover the contract, it is declared void.
B. Bar the writing of new CDS on any TARP recipient. The government has said it will not allow these firms to fail. The bets have been made; existing ones that can be covered by the writer are ok, but no new positions can be opened until the government's interest is extinguished in that name.
C. Require that all new CDS be written against a public exchange and direct the ISDA to produce, immediately and nightly until that has taken place, bid/ask/OI on an accessible public interface.
D. Consider barring all CDS that are written "naked" - that is, not against a deliverable bond. There are already-existing means to short a firm you believe is in trouble in the equity, options and futures markets. The inversion of the risk:reward profile in the CDS market is a big part of the problem and we must consider putting a stop to it.
E. Do this all right here, right now. Give market participants a very short term (two weeks, maybe four) to get their act together or face having their contracts rendered noncollectable.

2. Send in the bank auditors and examiners, suspending all bank share trading for two weeks. Mark everything to the market. Anyone who is insolvent under Tier Capital rules gets crammed down ala-The Genesis Plan. All firms that are crammed down have their boards and management removed; the new equity holders (former bondholders) get to elect new management to run the firms they own without prejudice (if they want the old management back, they're welcome to have 'em, but there is no ability to manipulate the vote by entrenched management!) All firms then re-open for trading at the same time - but existing shareholders (including preferreds) of the "crammed down" are wiped out.

3. For those firms that cannot survive even when crammed down they are instead seized by the FDIC and RTC'd. This works exactly as it did in the RTC days; the FDIC gets the assets in exchange for guaranteeing deposits, and disposes of them in its self-funded "bad bank." That is a "bad bank" model that can and will work and has no "asset valuation" issues.

4. Be prepared to use the second half of the TARP funds to either internally capitalize new banks which will then be spun off to the public or add capitalization to existing good banks. The cramdown and receivership of the bad banks will undoubtedly lead to lots of guaranteed deposits and good assets needing a home. There are hundreds of perfectly solid existing banks that should be permitted to grow their asset and deposit base by feasting on the carrion of the deposed.

5. Start investigating the fraud, and be vigorous about it. The public is not going to sit for their 401ks being destroyed as they have already (and will be as this plays out) without blood. There are lots of bad actors out there, starting with the officers and boards of failed institutions. These were not just "bad bets" that caused our banking system and economic problems - I'm willing to wager that it can be proven that they were knowingly-unsound bets and the mismarking of "asset values" was not accidental either. Down this road should lie plenty of securities fraud charges and maybe more than a bit of Racketeering. Go for disgorgement of the ill-gotten gains to at least provide the people with something to refill the treasury and assuage the anger, along with prison sentences.

There is no "market-friendly" solution to this mess folks. There are, however, disastrous decisions that can be taken, and continuing to hide losses - and the truth - will lead directly to that disaster.

We must deal with the bad debt by forcing it into the open. Transferring it from one pocket to another fixes nothing and if we're not careful we will wind up precipitating a bond market collapse coincident with the stock market melting down to a degree that is several times worse than what we saw in September and October.

Ditto rmark and†¦

Look at some tech companies that built up huge cash balances in there rise and spent the money down in their decline. Management would rather use the cash to keep to their jobs even as the company declines than to use it to buy back shares.

Against I surely could be wrong but that is how I see it now. I would love to learn that I am wrong because then I could improve my investing.

I don't know if it's true or not, but one reason I've heard given for dividends is that they are a requirement to be held by some pension funds. Otherwise, it seems that dividends should only be released if firms have limited opportunities for investment of retained earnings in projects providing adequate risk-adjusted returns.

Dave: Oops. They're all insolvent. Now what?

Bankruptcy. Liquidate were necessary. The FDIC cover the depositors. Use TARP funds to create new banks.

It is better for the individuals and corporations to go bankrupt and start over than to transfer the insolvency to the federal government. What happens when the government is insolvent?

At least for the duration of the crisis, and possibly permanently, any firm that can't *prove* its solvency (i.e. ability to pay all its outstanding obligations in full) shouldn't be allowed to pay dividends. A firm that pays dividends and then declares bankruptcy has defrauded its creditors, just as in your example, even if it's far less obvious (and even if the firm didn't know it was insolvent at the time it issued the dividends).

Currently, that probably includes all banks. Some may actually be solvent but just can't prove it yet - tough. Until your arcane financial instruments actually return whatever they return - in some form with an ascertainable *stable* value - their value is unknown and you can't count them to prove verifiable solvency. (This is deliberately tougher than mark-to-market, because the market can go down. If you want to count your assets at their current market value, *sell* them at their current market value - now you hold cash, which has a definite value.) Similarly, variable-value liabilities have to be counted at their worst-case value for provable solvency purposes.

Verifiable solvency is thus a much stricter standard than actual solvency, because you have to count all your potential and actual liabilities (other than shareholder equity; presumably the shareholders don't object to the dividend, or could stop it if they did) but you can only count your assets that have provable stable values. This means you have to wait for the roulette wheel to stop before claiming to be a winner.

I'm at a loss. Isn't the primary purpose of shares the dividends? Everything else being derivative. I mean, yes, there are share buy-backs, but why would a company bother to buy back shares when those shares aren't costing them anything by being in other people's hands? (Except voting privileges.) And if the company won't buy back shares, the shares are worthless to everyone else (except voting privileges) unless the buyer can line up yet another buyer who'll pay more. And if they _can_ find another buyer who'll pay more, it's because they're engaged in a pyramid scheme type process.

Regardless, I'd prefer if the government got something like equity for its money.

James O'Hearn,
tradition may be the answer.

Most jurisdictions tax capital gains at less than normal rates and treat dividends either as earned income or as capital gains. Some jurisdictions encourage "buy and hold" by requiring the assets to be held a year to qualify for the reduced taxes. Did you mean 14.55%? That's what I found at the highest tax bracket, while capital gains are 14.50. At lower tax brackets, dividends have significantly lower taxes than capital gains.


The actual tax rate for dividends in Canada is higher, however changes to the tax code in the past several years have meant that, on returns, there are various deductions and exemptions regarding dividends with the end result that the effective payable rate is 4.55%.

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