Fed Questioned For 'Passing' Goldman, Morgan Stanley on Stress Test

The Federal Reserve faces new questions from a pair of Democratic U.S. senators over its decision to give passing grades to Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS)  on a recent "stress test", despite results showing the two Wall Street firms would have tripped regulatory minimums.  

Senators Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio wrote in a letter to Fed Chairman Jerome Powell on Tuesday that the passing grades "are effectively a gift to the banks, specifically their shareholders, including executives well-compensated in company stock." 

The Fed said last month that Goldman and Morgan Stanley received a "conditional non-objection" on the annual stress tests of the largest U.S. banks. The tests are conducted to determine if banks would maintain sufficient financial strength during a hypothetical severe recession and market downturn while still making payouts to shareholders in the form of dividends and stock buybacks. 

While both Goldman and Morgan Stanley would have passed the test prior to any payouts, they both would have failed under their original plans for dividends and stock buybacks, according to the Fed. In response, the Fed allowed the firms to keep making payouts but restricting them to the prior year's levels.

"Had the firms failed, they would have needed to seek express permission from the Fed for every stock buyback or dividend over the next four quarters," the senators wrote. 

The cash for dividends and share buybacks comes out of banks' capital, which is also supposed to insulate the firms from big loan defaults or trading losses that might lead to failure or a government bailout.

The Fed didn't object to more than 30 other capital-distribution proposals by big banks, including those of JPMorgan Chase & Co. (JPM) , Bank of America Corp. (BAC) , Citigroup Inc. (C) or Wells Fargo & Co. (WFC) . 

In an e-mailed statement, a Fed spokesman said there were "no negotiations" with the firms over the level of payouts, and that officials at the central bank followed the same procedures as in prior years' stress tests.

"All firms were notified of the results and given a fixed option to reduce their capital payout plans," the spokesman said.   

Press representatives Goldman and Morgan Stanley didn't respond to requests for comment. 

The senators wrote in the letter that they were especially troubled by news reports suggesting that Fed officials provided "special forbearance" to the two firms to help them "avoid the black eye of failure," in a move that "seems inconsistent" with the central bank's policy of "consistent and equitable treatment" of the banks.    

According to the Fed's statement last month on the stress-test results, Goldman and Morgan Stanley each would have tripped a "leverage ratio" -- one test of capital that the Fed uses -- in the hypothetical severe recession. The minimum for the leverage ratio is 3%; Goldman's would have fallen to 2.6% under its original capital plan, while Morgan Stanley's would have dropped to 2.5%.

Rather than fail the firms, which would have prevented them from making regular capital distributions without prior approval, the Fed decided to allow them to keep their payouts at the prior year's levels. A senior Fed official told reporters at the time that part of the logic came from the fact that the banks will earn money at a higher level during the coming year due to President Donald Trump's tax cuts, which slashed the corporate rate to 21% from 35%.

In their letter, the senators asked Powell to detail when the Fed contacted Goldman and Morgan Stanley to "negotiate or discuss the potential failure" on the tests, and who was involved in the talks. They also asked about the "process by which the Fed determined that Goldman Sachs and Morgan Stanley could maintain prior capital distributions." 

More from Markets

State Street Gets Pummeled on Software Deal; Pizza Wars Are Raging -- ICYMI

State Street Gets Pummeled on Software Deal; Pizza Wars Are Raging -- ICYMI

Schlumberger Stock Dips as Investors Ignore Start of 'Earnings Liftoff'

Schlumberger Stock Dips as Investors Ignore Start of 'Earnings Liftoff'

GSK Shares Climb as Board Is Said to Mull Breakup of Pharma Giant

GSK Shares Climb as Board Is Said to Mull Breakup of Pharma Giant

Stocks End Close to Home

Stocks End Close to Home

Jim Cramer on Bank of America, Tariffs and the Goldman Sachs CEO Change

Jim Cramer on Bank of America, Tariffs and the Goldman Sachs CEO Change