Fed favors loans over dividends

The Federal Reserve has encouraged some banks to cut dividend payments to preserve money for lending, Eric Rosengren, president of the Federal Reserve Bank of Boston, said yesterday.

Such cuts mean shareholders receive less money. But reduced profits and increased expenses have forced some banks into a choice between using money to pay shareholders or to make loans.

Rosengren said the Fed was concerned that a reduction in lending could damage the struggling economy.

"We are encouraging institutions to take a look at their situation, and where appropriate to either reduce their dividends or cut their dividends," Rosengren said during a meeting with Globe reporters and editors. "That's one way to make sure that they retain more capital and that means you don't have to shrink as much."

Banks can also raise new capital by selling stock or accepting an infusion from investors, and Rosengren added that the Fed was "agnostic" as to how banks preserve their lending capacity.

He declined to say which banks had been prodded. Several of the largest US lenders have cut dividends this year, including Citigroup Inc., Wachovia Corp., and Washington Mutual Inc.

During a wide-ranging conversation, Rosengren reiterated his recent statements that the US economy is "on the cusp" of recession. He added that the difference between a shallow recession and a near miss was negligible; either way, unemployment will increase and many people will suffer financially.

But Rosengren said New England was likely to suffer less than other regions, because home building and other hard-hit sectors are a relatively small part of the regional economy.

Rosengren, who took over the Boston Fed last summer, said he believed the Fed should have cut interest rates more quickly last year to counteract the slowing pace of economic growth.

In December, when the central bank's Federal Open Market Committee cut interest rates by a quarter percentage point, Rosengren was the only member who voted to cut rates by a half-point. He has since rotated off that board, but said he approves of more recent decisions to cut rates sharply.

"While I might have done something differently at the December meeting, I've been perfectly happy with what we've done all through the spring," Rosengren said. The cuts, he said, are "a positive sign for how long this actually will take" until the economy improves.

The duration is uncertain because the cause is unprecedented. The economy boomed in recent years because it found a more efficient source of funding: securitization, or selling large packages of small loans to investors. But confidence in the quality of those securities has collapsed, triggered by unexpectedly high losses on securitized mortgage loans that were marketed as safe investments.

As a result, some of the largest banks have been stretched thin, simultaneously forced to take ownership of old loans, even as the flow of new profits fell sharply. That has limited their ability to make new loans, and the outflow of dividend payments has tended to exacerbate the issue.

The Fed has publicly encouraged banks to reconsider the size of their quarterly payments to shareholders.

"Dividend policies definitely should be on the table, as they have been for a number of institutions already," Fed vice chairman Donald Kohn testified before Congress in March. Rosengren's remarks seem to be the first indication the Fed has encouraged specific companies to cut payments to shareholders.

Washington Mutual slashed its dividend in December from 53 cents a share to 15 cents a share, and sold new shares, after regulators advised the bank to increase its capital.

In January, Citigroup cut its quarterly dividend from 54 cents a share to 32 cents, saving $1.1 billion each quarter. The bank said at the time that it took the step to preserve capital. And on Monday, Wachovia cut its dividend from 64 cents a share to 37.5 cents, saving about $500 million each quarter.

Wachovia chief executive Ken Thompson said the bank was not responding to federal regulators.

"We had no regulator at any time approach us and ask us to raise capital to cut our dividend. Zero. Not one conversation. This was a decision that we made based on our belief that the right thing to do at this point was to take on a lot of capital and get prepared," he said, according to a transcript of the bank's earnings call with investors.

The moves have troubled some shareholders. Banking analyst Nancy Bush called herself "tremendously torn" about the wisdom of banks cutting dividends to build up assets, since it harms long-term investor confidence.

The Fed "wants capital so banks can continue to lend so we get out of this credit crunch," she said in an interview yesterday. "But their thinking to me is very short-term. What if we come out of the crunch and everybody thinks the banks are junk? That's a problem for future lending and confidence in the banking industry."

Other sources of funding have their own minefields. Several banks have accepted large infusions of capital from the investment arms of foreign governments, raising concerns in some quarters about foreign control of the American economy.

Asked about those concerns, Rosengren noted that banks unable to find money elsewhere could eventually be forced to turn to taxpayers, in the form of the Federal Deposit Insurance Corp.

"I think our primary goal is that [the money] doesn't come from the FDIC," he said.

Binyamin Appelbaum can be reached at bappelbaum@globe.com. Ross Kerber can be reached at kerber@globe.com.