Friday, June 26, 2020

Expect Dividend Cuts and Dividend Freezes in the Banking Sector

Update 06/29/2020: Wells Fargo (WFC) announced that it may have to cut dividends after releasing results on July 14, 2020. Source: WFC Announcement

The Federal Reserve released its information on bank stress tests yesterday - June 25, 2020. You can read the announcement at this link. I found the following information very interesting, as it pertains to investors:

"For the third quarter of this year, the Board is requiring large banks to preserve capital by suspending share repurchases, capping dividend payments, and allowing dividends according to a formula based on recent income. The Board is also requiring banks to re-evaluate their longer-term capital plans.

All large banks will be required to resubmit and update their capital plans later this year to reflect current stresses, which will help firms re-assess their capital needs and maintain strong capital planning practices during this period of uncertainty. The Board will conduct additional analysis each quarter to determine if adjustments to this response are appropriate.

During the third quarter, no share repurchases will be permitted. In recent years, share repurchases have represented approximately 70 percent of shareholder payouts from large banks. The Board is also capping dividend payments to the amount paid in the second quarter and is further limiting them to an amount based on recent earnings. As a result, a bank cannot increase its dividend and can pay dividends if it has earned sufficient income."

I bolded the words to show you the support behind my analysis.

It basically boils down to the fact that banks will experience credit losses due to high unemployment, and the recession related to Covid-19. The bank system is sound, and can survive a recession, as well as a potential W or V shaped recovery. There may be fewer casualties, in comparison to the Great Recession from 2007 - 2009. Therefore, the Federal reserve expects fewer bank failures from the larger companies.

However, in order to maintain liquidity and capital reserves, banks cannot do share buybacks for the third quarter. It is likely that banks won't be able to do share buybacks until the recession is over. That may mean that they won't be able to take advantage of "low prices", due to government regulation.

Banks can still continue paying dividends, but they will be unable to raise dividends for the duration of this recession. It would be nice if we just get away with dividend freezes - meaning dividends are unchanged. Financial dividends will return after the recession is over, and the stress tests allow them to do so.

The trouble is if banks report losses due to loans deteriorating due to the recession. If they are temporarily unable to earn enough to pay the dividend, they have to cut dividends. In other words, if Wells Fargo loses money in Q3 2020, it would have to cut dividends or suspend them, even if the bank recovers in Q4 2020. I doubt that a recovery would be so quick, as it looks today that we are headed for a second wave of Covid-19 cases, and potentially a second shutdown.

It also looks like the Federal Reserve is viewing share buybacks differently from dividends. It makes sense, because companies usually allocate any residual excess cash flows to buybacks that are not committed to dividends or growing the business. Buybacks can be best viewed as special dividends, so they are not recurring, and dependable like dividends.

I have a small allocation to banks. I will be selling if we have dividend cuts however. If a company maintains dividends, I will hold on to it. Perhaps I would finally learn the lesson that banks are cyclical companies, which cannot pay dependable dividends through the ups and downs of the economic cycle.

Selling financial companies after a dividend cut worked well early in the last recession, mostly in 2007 and 2008. Selling after a dividend cut was a mistake in 2009. Either way, it is important to stick to a plan, through thick or thin!

Relevant Articles:

TARP is bad for dividend investors
Which Bank will be next? Follow the dividend cuts
Dividend Investing During the Financial Crisis
Six things I learned from the financial crisis

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