Banking & Finance

Hints of Big Dividend Cuts for Major Banks Overlooked in FOMC Minutes

When the economy went into panic mode and the insta-recession was becoming unavoidable, many major companies and small companies alike began taking immediate action to either maintain strong liquidity or they took efforts to raise capital. On top of layoffs, furloughs, offices closures and other expense cuts, companies began slashing their capital allocation efforts. Acquisitions and share buybacks were abandoned, and many companies even resorted to slashing their dividends.

The U.S. banking giants had been very aggressive in buying back stock, and the Federal Reserve’s regulatory oversight group had become very lenient in terms of high dividends in recent years. The new COVID-19 recession has changed many aspects of just how healthy the big banks may be after years of being deeply overcapitalized. There have been some Federal Reserve officials who have suggested that the major banks, even after they have ceased buying back their own shares, should be cutting the dividend payments to their common shareholders.

The Federal Reserve has now released its Minutes from the April 29, 2020 FOMC meeting. It is easy to understand how concerned and how worrisome some of the commentary might be. While the Fed’s dual mandate is to maintain acceptable inflation levels and to maximize employment, the Fed has no real worry about inflation at this time and it should be very worried about unemployment.

And while the commentary is dreadful around the mandates, the commentary retail sales, production, business conditions, sentiment, global trade and just about everything else was also very cautious. One aspect that stood out in the Minutes was that some of the FOMC’s participants have voiced more concerns that banks could find their operations and and their balance sheets under greater stress.

Where the real concerns seem to be focused in on the adverse scenarios if the spread of the pandemic continued and if economic activity continue to weaken. The Minutes even spelled out about the banks — this sector should be monitored carefully.

Monitoring the FOMC Minutes throughout the year is generally a boring task. The problem in failing to monitor the Minutes comes with a price of missing out on major developments or undercurrents which are often presented only in hints or suggestions.

24/7 Wall St. has a key takeaway here and that takeaway is that bank stock investors better expect at least some common stock dividends to get cut and for those common stock buyback plan suspensions to remain under suspension for a longer period of time.

The FOMC Minutes do not include a single instance of the word “dividend.” And while the term “payout” is only used once, the writing is all over the wall that bank stock dividends could still come under fire. Some Fed presidents and former officials have said in recent speeches, interviews and other events that the banks should cut dividends. others have signaled that the dividends are able to be maintained due to massive capital that had been built up in the last decade.

It remains to be seen whether or not the big banks will be forced or will volunteer to cut their dividends. They have already suspended stock buybacks to preserve capital, but cutting the dividends comes with a deeper stigma and can come with greater investor backlash. Some additional concerns that were also addressed were on high debt, counterparty or collateral risks, and even insolvency. The FOMC Minutes specified:

Participants saw risks to banks and some other financial institutions as exacerbated by high levels of indebtedness among nonfinancial corporations that prevailed before the pandemic; this indebtedness increased these firms’ risk of insolvency.

One aspect that needs to be considered ahead is that the so-called adverse scenarios and great downside scenarios that had been used in 2018 and 2019 were beginning to feel too harsh for capital levels. After the COVID-19 pandemic caused a global recession, almost every aspect of the broad economy suffered. That also means that the banks are suffering, and suddenly the greatly adverse scenarios used in prior stress tests look somewhat generous now that there was an unprecedented total lock-down of the economy. The Minutes included a warning about payouts, i.e. dividends and buybacks, as follows:

The upcoming financial stress tests for banks were seen as important for measuring the ability of large banks to withstand future downside scenarios. A number of participants emphasized that regulators should encourage banks to prepare for possible downside scenarios by further limiting payouts to shareholders, thereby preserving loss-absorbing capital. Indeed, historical loss models might understate losses in this context. A few participants stressed that the activities of some nonbank financial institutions presented vulnerabilities to the financial system that could worsen in the event of a protracted economic downturn and that these institutions and activities should be monitored closely.

Bank of America Corporation (NYSE: BAC) currently has close to a 3.2% dividend yield, but at $22.90 it would still need to rally over 50% to reach its 52-week high of $35.72.

Citigroup, Inc. (NYSE: C) now comes with a dividend yield of roughly 4.5%, but at $49.50 its shares would have to rally almost 70% to hit its 52-week high of $83.11.

J.P. Morgan Chase & Co. (NYSE: JPM) has a 4% yield on its common stock dividend. With a price of $91.00, it would also have to rally more than 50% to reach its all-time high of $141.10. Jamie Dimon has already addressed back in early April that JPMorgan Chase would consider suspending its dividend under the worse case scenario. Many other banks are just not as well capitalized as Team Dimon.

Wells Fargo & Company (NYSE: WFC) comes with the biggest red flag of the major banks. Its 8.3% dividend yield is due to a share price down at $24.52. It is up the least from its post-panic selling low of $22.00, the fact that it would have to rally 123% to hit its 52-week high of $54.75 only tells part of its dismal story here. Wells Fargo’s stock reached a zenith of $66.00 back in early 2018, nearly 200% higher than the current price.

U.S. Bancorp (NYSE: USB) has also historically been considered one of the better run and capitalized banks. At $33.10, its current dividend yield screens out at almost 5.1%. Its 52-week range is $28.36 to $61.11.

The PNC Financial Services Group, Inc. (NYSE: PNC) recently announced it was about to have its strongest capital position ever due to the sale of its entire BlackRock stake. At $105.15, it would still have to rally some 50% or more to hit is prior high of $161.79. PNC’s dividend yield is still close to 4.5%.

State Street Corporation (NYSE: STT) and The Bank of New York Mellon Corporation (NYSE: BK) are also both handily down from their highs as they are facing margin pressures from their custodial business with short-term interest rates near zero. Their dividend yields of 3.6% or so are also both artificially high.

If regulators and Fed officials have discussed potential capital raising efforts for banks, other capital allocation plans such as dividends and buybacks would be an easy alternative to tapping new capital when the cost of borrowing or issuing equity might be considered too expensive in a low-rate environment.

With the major banks having already passed the April due date for their own capital ratio reviews under various scenarios, the Federal Reserve’s stress test (Comprehensive Capital Analysis and Review) expected to be on or before June 30, 2020, the Federal Reserve could have some unpleasant news for bank stock investors who have been counting on those dividends. Unless the economy is improving handily by that time, those suspended stock buyback plans may also face some extensions that are longer than bank stock investors had grown used to for the last five years or more.

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