The purpose of this post is to analyze data and factors that influence the banking industry’s ability and willingness to pay cash dividends. There are five reasons bank dividend cuts appear imminent. The implications of bank dividend cuts are far-reaching and touch on not only the health of individual banks, but the safety and soundness of the banking system. Moreover, as the banks learned a decade ago during the Great Panic of 2008-2009, bank CEOs and bank regulators need to be much more savvy and aware of the politics of banking. The fact that the Covid-19 Crisis hit in an election year makes bank dividends a political lightning rod.
This analysis begins with an overview of the five reasons dividend cuts appear imminent and closes with a description of how the rationale for dividend cuts could be communicated by leading bank CEOs and bank regulators. This analysis also includes a risk assessment of the politics of bank dividends.
Reason 1: 26 Million Jobless, Rapid Decline in GDP
In my 2016 book, Investing in Banks, I introduced bank investors to the “Law of GDP.” Quite simply, bank profitability is highly correlated to GDP. As rain is to farmers, GDP is to bankers.
We know GDP is in the tank, but we not yet know in April 2020 how badly. US Jobless Claims over the past five weeks exceed 26 million as Figure 1 shows. This massive number is not only heartbreaking, but portends serious trouble ahead for 2nd quarter (and beyond) GDP.
The magnitude of the distress facing US consumers and businesses is reflected in the extraordinary comments made by bank executives during earnings calls last week. Here are just three examples.
During its April earnings call, Bank of Marin Bancorp (BMRC), a highly regarded $2.7 billion California community bank, reported that “approximately $322 million in loan relief requests or conversion to interest only or payment deferral” had been made as of April 14. That number represents 17% of the bank’s March 31 loan balance.”
Ally Financial Inc. (ALLY), a $167 billion auto lending bank, experienced even higher borrower deferral requests as the bank’s CFO reported during its April 20 earnings call:
“If you look at our forbearance population, starting first within retail, it’s 1.1 million customers. It’s about 25% of our accounts, a little bit higher than that in terms of the balances… On the commercial side, we have about 73% or so of our dealerships that are taking advantage of payment deferral.”
During its April 23 earnings call, the CEO of Umpqua Holdings Corp. (UMPQ), a $29 billion regional bank headquartered in Oregon, provided this insight that speaks to the disruption the Covid-19 shut-down is having on small businesses.
“… in a normal year Umpqua generates approximately $140 million in SBA loans. In less than two weeks, Umpqua produced more than 10 times a typical year’s production…”
Bank of Marin, Ally, and Umpqua are just three of the nation’s nearly 5,000 banks. Few of the nation’s banks will dodge the need to provide temporary assistance to customers. Huntington Bancshares Incorporated (HBAN), the top small business lender in the Midwest, reported earlier in April that it expects that it will do a year’s worth of small business loans (35,000 loans) during the first week of offering the new Paycheck Protection Program. Huntington is certainly not unique in its PPP experience.
The Covid-19 Crisis has inflicted enormous damage to the cash flow and balance sheets of consumers and businesses. What’s even more troubling, as the US Jobless Claims chart shows, the nation is just five weeks into this crisis. No one knows when the economy will begin to heal.
Accounting: The chief accounting officers of banks must be working overtime to determine the appropriate accounting policies needed during this unprecedented time. The full extent of their work will become more apparent in the 2nd quarter as banks release standard quarterly reporting. Because banks operate under strict accounting standards, banks will have limited ability for “creative” accounting that could conceal the full impact of loan forbearance programs.
Regulatory: Much to their credit, US bank regulators (the Federal Reserve Board, the Office of the Comptroller of the Currency, and the FDIC) appear to have been highly responsive to the need for banks to receive their own forbearance from restrictive accounting and regulatory rules. Evidence can be seen at the OCC’s website which provides a list of actions it has taken to give banks some regulatory relief during this time. The Federal and FDIC have done likewise.
Economic: High performing typically have an Efficiency Ratio close to 50. This ratio is calculated by dividing non-interest expenses (personnel, occupancy, other) into adjusted operating income (essentially, net interest income plus non-interest fee income). A low ratio means the bank is more efficient. All banks that enter into borrower forbearance programs stress their Efficiency Ratio. The nation’s least efficient banks, which are almost all community banks, will feel the stress sooner and most acutely.
Political: Bankers and regulators must not ignore the politics of banking. The longer banks wait to announce dividend cuts when so many Americans are unemployed, the greater the likelihood that bank dividends will become an election year political issue.
2. Jamie Dimon Foreshadowed Dividend Cut on April 6
JPMorgan Chase & Co. (JPM) released its 2019 Annual Report on April 6. The annual report included a 22-page letter from its inestimable chief executive officer, Jamie Dimon. In the letter Dimon gave a not-so-veiled warning about the bank’s dividend.
“… we have run an extremely adverse scenario that assumes an even deeper contraction of gross domestic product, down as much as 35% in the second quarter and lasting through the end of the year, and with U.S. unemployment continuing to increase, peaking at 14% in the fourth quarter. Even under this scenario, the company would still end the year with strong liquidity and a CET1 ratio of approximately 9.5% (common equity Tier 1 capital would still total $170 billion). This scenario is quite severe and, we hope, unlikely. If it were to play out, the Board would likely consider suspending the dividend even though it is a rather small claim on our equity capital base. If the Board suspended the dividend, it would be out of extreme prudence and based upon continued uncertainty over what the next few years will bring.”
A friend called me immediately after reading Dimon’s letter and said, “Jamie is preparing investors for a dividend cut.” I think my friend is right.
Four days later JPM’s economists reported that their 2nd quarter GDP forecast had dropped to a staggering -40%. Note that the -40% second quarter GDP number is worse than the extremely adverse scenario of -35% referenced in Dimon’s April 6 letter to shareholders as well as worse than Fed Stress Tests.
Here is what JPM’s CFO had to say during the bank’s Q1 earnings call on April 14 about the sudden decline in the economy.
“…as we closed the books for the first quarter, just to give a context, we were looking at an economic outlook that had GDP down 25% in the second quarter and unemployment above 10%….Since then, as I noted in my prepared remarks, our economists have updated their outlook and now have GDP down 40% in the second quarter and unemployment at 20%. That’s obviously materially different.”
As the nation’s most respected banker, expect JPM’s CEO to be among the first banks to announce a dividend cut. By leading the way, Dimon will give other bank CEOs the air coverage to cut their own banks’ dividends. If and when dividend cuts are announced, expect Dimon, other bank CEOs, as well as regulators and the Trump White House (accountable for the political appointments at the FDIC and OCC) to state emphatically that banks are well-capitalized (see below) and the banking system safe and sound.
Reason #3: Provision Expense Will Hit 11-Year High in Q1 2020
Regular readers of my bank writing know that one of my favorite bank metrics is “Provision as a % of Loans.” I like this metric because it is highly correlated with bank profitability. Based on my review of first quarter earnings reports from 40 banks, I estimate that the banking industry’s 1Q 2020 Provision/Loan rate to hit a 10-year high of.63% as can be seen in Figure 2. It should be noted, as the chart shows, a pop in Provision one quarter is almost always followed by several quarters of elevated Provision expense.
Before discussing the Provision/Loan rate in further detail, it is helpful to examine the 1Q 2020 Provision/Loan rate of 35 banks as reported in their press releases during the past two weeks. See Figure 3.
Note that Provision rates vary tremendously across banks depending on business strategy. Banks like Capital One Financial Corporation (COF) that focus heavily on unsecured consumer credit have high Provision rates. Banks like First Republic Bank (FRC) and Northern Trust Corporation (NTRS) that serve highly affluent clients historically have had low Provision rates. Megabanks like JPM and Bank of America Corporation (BAC) have business models that cut across multiple customer segments, so they report Provision not only for the enterprise but for individual lines of business.
The Covid-19 Crisis wreaks terrible financial damage to Americans living paycheck to paycheck. Banks serving the “Mass Market” segment are most likely to see the biggest spikes in Provision expense in the quarters ahead if the economy does not get back on firm footing a few months from now when government transfer funds are exhausted.
Figure 3 reveals that banks are all over the board when it comes to Provision/Loan rates for the first quarter. Without getting into a lot of detail, a few headlines observations can be made.
First, banks are flying blind into the Covid-19 Recession (Depression?). Given that there is no precedence for what banks are now enduring, they are struggling with a profound number of unknowns. First quarter earnings calls included these comments about “unknowns” and “uncertainty” from several of the nation’s leading bankers.
• “… a lot will depend on the ultimate effect of these extraordinary programs and how effective they can be in bridging people back to employment. And we’re going to still have a number of unknowns… but we’re going to learn a lot through these next few months that will inform our judgment for second quarter reserves.” (JPMorgan Chase CFO, April Earnings Call)
• “Sitting here today, there are many unknowns, and the year will look quite different than we expected the last time we spoke.” (Wells Fargo & Co. (WFC) CEO, April Earnings Call)
• “Obviously, there are many unknowns including how government, fiscal and monetary actions will impact the outcome… But perhaps the biggest unknown is how long economic activities and conditions will be significantly impacted by the virus.” (Bank of America Corporation (BAC) CFO, April Earnings Call)
• “So, trying to give you some precise science with all of these unknowns out there, I just — I don’t think it’s a useful exercise.” (The PNC Financial Services Group, Inc. (PNC) CEO, April Earnings Call)
• “And, obviously, right now, there are a lot of unknowns, a lot of uncertainty.” (Comerica Inc. (CMA) CEO, April Earnings Call)
• “Significant uncertainties as to future economic conditions exist.” (Texas Capital Bancshares, Inc. (TCBI) April Earnings Press Release)
• “… the near-term level of uncertainty is unprecedented…. In this environment of uncertainty, it is hard to predict what can or will happen and the impact it will have on us.” (1st Source Corporation (SRCE) April Earnings Press Release)
Second, further complicating the Provision picture in the first quarter was the long-anticipated and much-loathed introduction on January 1 of the Current Expected Credit Loss methodology – i.e., “CECL” — by the Financial Accounting Standards Board. While this article about bank dividends is not the place to vent my eight years of frustration with the FASB’s wrong-headed decision to impose a new and unreliable methodology for bank Provision expense, I must say that the new rules could not have come at a worse time. US bank regulators apparently agreed as they pressured FASB to back off on the timing of CECL’s introduction which FASB finally did on March 27.
However, FASB’s last-minute reprieve did not help the banks since most had already finished their CECL analysis and reporting much earlier in the quarter. Back to Figure 3, it is important to note that almost all banks reported Provision in Q1 reflecting the adoption of CECL which caused many banks to increase their Loan Loss Allowance (a contra asset) which is funded by Provision expense.
Here is an example: Synchrony Financial (SYF) had a Provision expense in Q1 equal to 11.13% of its quarter-end loan balance; of that total, $3.12 billion of the bank’s $9.175 billion in first quarter Provision was related to a one-time (?) adjustment to the Loan Loss Reserve because of the new CECL rules.
While the expected .63% Provision rate for the industry is high and disconcerting, it must be noted the untimely introduction of CECL, as can be seen in the Synchrony example, adds considerable “noise” to the Provision number at a time when the economy is falling off the cliff.
However, even absent the impact of CECL, Provision in the 1st quarter would have jumped to a ten-year high based on my analysis of the Provision expense of the big banks. My best guess is that industry-wide Provision without CECL would have been approximately .50%.
Figure 4 shows the Allowance for Loan Losses for a group of banks as of March 31. Many bankers, myself included, regard the Allowance as another form of equity that cushions banks from loan losses.
First quarter earnings reports are ancient history at this point. The focus is now on second quarter Provision and bank earnings potential until a vaccine is available and the economy healthy again. Banks are not alone in flying blind. So too are bank investors. Evidence can be seen in the following chart that shows the stunning range of 2nd quarter earnings estimates for the nation’s five biggest banks. Figure 5 indicates that there is no consensus among bank analysts about bank earnings and Provision expense for second quarter. Bank investors are wise to proceed cautiously before adding to bank holdings.
Investors in Wells Fargo will want to be especially alert to any announcements the bank might make about Provision and Loan Loss Allowance prior to its 2nd quarter earnings report in July. As figures 3 and 4 show, WFC has materially lower Allowance than peers. This suggests WFC has a more pristine credit portfolio than peers. Time will tell.
Reason #4: Federal Reserve Bank President Urges Banks to Reduce Dividends
On April 16, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis and 2014 candidate for governor of California, wrote an op-ed for the Financial Times calling for banks to do “the most patriotic thing they could do today” by deciding “to stop paying dividends and raise equity capital, to ensure they can endure a deep economic downturn.”
Kashkari has a reputation for being outspoken. Readers of his op-ed must pay heed to his warning that “stress test modelling by the Minneapolis Fed indicates that under severe Covid-19 scenarios, large banks, those with assets greater than $100bn each, could together lose hundreds of billions of dollars of equity capital.”
To lose “hundreds of billions” is an ominous statement coming from a Federal Reserve Bank president. Figure 6 puts that number in perspective. This chart shows that banks lost $179.6 billion over the five quarters starting Q4 2008. In contrast, banks earned $236 billion in 2019.
Figure 7 indicates that banks in 2019 paid out cash dividends of $184 billion. Kashkari argues that banks should save the cash and retain capital in the near term to offset losses the Minneapolis projects under a severe Covid-19 scenario.
Against the backdrop of Kashkari calling for banks to hold back dividends and build capital, it is crucial that bank investors understand that banks today are better capitalized than at any other time in history. Figure 8 shows that the industry’s Tier 1 Risk-Based Capital Ratio is 30% higher than in 2008. As of 12/31/2019, the FDIC reported that banks collectively held $1.73 trillion in Tier 1 Risk-Based Capital and $2.11 trillion in Total Equity Capital. The good news is that the industry has significant capital to losses.
To that point, nearly every bank chief executive officer touted their bank’s capital as a source of strength during first quarter earnings calls.
• “Our balance sheet remains strong with sufficient capital” (Ally Bank CEO, April Earnings Call)
• “We remain well-capitalized” (U.S. Bancorp, (USB) CEO, April Earnings Call)
• “We have solid liquidity and capital positions” (PNC CEO, April Earnings Call)
• “We have deep liquidity reserves and a strong capital position.” (Capital One Financial Corporation, (COF) CEO, April Earnings Call)
• “We entered this crisis in a very strong position from a capital, liquidity and balance sheet perspective.” (Citigroup Inc., (C) CEO, April Earnings Call)
• “The bottom-line is that we have the strongest, highest quality balance sheet in our history including ample liquidity.” (SVB Financial Group (SIVB) CEO, April Earnings Call)
The potential for a loss in the hundreds of billions of dollars cannot be discounted given the vast number of unknowns bankers face today.
While the industry is well-capitalized, a loss of $200 billion would prove painful. A loss of the magnitude of $800 billion would be a game-changer that would raise safety and soundness concerns and put hundreds of banks out of business. (The U.S. has roughly 5,000 banks.)
My informed guess is that the industry can absorb $100 billion to maybe $300 billion without needing to go to the capital markets for highly dilutive new capital. As a long-term bank investor, I would prefer to see my banks reduce or even eliminate dividends temporarily if the action significantly reduces the probability of the bank needing to go to the capital markets for an equity infusion.
Reason #5: The Market Appears to Price Dividend Cuts into Current Bank Stock Prices
Reason #5 is another informed guess. It is my current view that dividend cuts are largely factored into bank stock prices today. Of course, that does not mean bank stock prices cannot drop further. Certainly, they can and likely will.
Figure 9 shows the median dividend yield for 69 banks that pay dividends. First, a caveat. The 69 banks do not include banks that failed in 1990-92 or 2008-10. Had failed banks been included in the data set, most probably the yields shown below in October 1990 and February 2009 would have been modestly higher. In this respect, the data set reflects survivor bias, meaning the banks in this population were strong enough in prior recessions to survive. A second caveat is that not all 69 banks have paid dividends since 1990; of the group, 41 have done so since 1990.
The chart shows that the 4.23% median yield on April 23 is at a peak seen historically only at times when the industry is on the brink of or during a recession. In the past when dividend yields have been this high, bank failures were unfortunately common. Nearly 3,000 banks and S&Ls failed from 1987-1992 and another almost 500 failed from 2008-2012. This is not to say that I expect banks to fail in the near-term, but dividend yields in April 2020 correspond to the yields seen at two other times of extreme bank stress.
Figure 10 is a scatterplot for 69 banks that shows the dividend yield (X-axis) and Z-score (Y-axis) for the current dividend yield. The Z-score provides a view of how the current yield compares to history (reflecting average as well as volatility).
Banks noted with red letters are banks that have current yields in excess of 6%. My research of bank dividend yields in 2008-09 shows that all but two banks that had dividend yields greater than 6% at that time eventually cut their dividend.
(The two exceptions are both headquartered in Upper State New York: Community Bank System, Inc. (CBU) which is among only 31 banks that raised their dividends in 2008 and 2009; the other bank is M&T Bank Corporation (MTB) which at the time was led by the legendary Robert Wilmers whose irascible spirit and sterling record for strong performance would not allow the bank to cut its dividend during the Great Panic. By the way, Wilmers was Warren Buffett’s favorite banker for years.)
On the other hand, banks that either maintained their dividend or increased it during the Great Panic (apart from the CBU and MTB), never saw their dividend yield exceed 6% during the tumultuous 2008-2009 timeframe (as calculated at month-end for those two years).
Figure 10 suggests that the market is already pricing in dividend cuts from the banks with dividend yields greater than 6%. No surprise, during 1st quarter earnings calls, executives of these banks were questioned about the dividend. As a group, the common answer was that the bank was determined, for now, to preserve the dividend. Here are comments about dividends from executives from five of the banks noted in red letters:
• “… we think the dividends, certainly that we’re paying, makes sense. But as I alluded in my prior comments, we don’t know what the future looks like based upon the assumptions that we’ve laid out in these very stressed environments.” (Wells Fargo CEO, April Earnings Call)
• “… we do stress tests for dividend… how the future might play out with COVID over the next several quarters… we feel good about dividend and believe it can be maintained.” (Comerica CEO, April Earnings Call)
• “And our stress testing through the most severe adverse scenarios, we assume that we continue with the dividend at current levels. And that’s our working assumption that we continue to manage the dividend at current levels…” (First Horizon National Corporation (FHN) CEO, April Earnings Call)
• “We expect to remain well capitalized and intend to maintain the dividend at the current level.“ (Citizens Financial Group (CFG), CEO April Earnings Call)
• “And so as we look forward, the regulators may come to a point that where they are recommending that the large banks do suspend dividend if they believe that the things are too dire. But I think that most banks would believe that we’re well positioned to continue to support those based on what we’re seeing in the economy today and based on our capital levels that we maintain.” (KeyCorp (KEY) CFO, April Earnings Call)
• “Our intention is to maintain the dividend at the current level. We think that we’ve got the right capital levels to support that, and we’ll continue to monitor it and model, but we think it’s the appropriate and sustainable level for now.” CFO Huntington Bank CFO, April Earnings Call)
The banks noted in black letters at the top of Figure 9 have current dividend yields that are significantly higher than recent history. Bank OZK (OZK) and Hancock Whitney Corporation (HWC) are two banks with a current dividend yield approaching 6% as well as much higher than each bank’s historic average dividend yield. These two banks may be the next to see their yields eclipse 6%.
Banks noted in green letters appear to be the banks the market least expects to cut dividends. Not only is CBU among these banks, but also Commerce Bancshares, Inc. (CBSH) and First Citizens Bancshares, Inc. (FCNCA). These are two of my favorite banks. CBSH, like CBU, raised its dividend during both 2008 and 2009. Both CBSH and FCNCA, despite being large banks, are both family-controlled, a factor that I consider to be a huge plus for bank investors.
Figure 11 is a bit messy. It shows the stock price by week of 13 of the nation’s largest bank stocks during 2008 and 2009. It shows that bank stock prices at that time tended to decline in anticipation of dividend cuts. In most cases, when the dividend was cut, the stock price started to flatten if not gradually increase.
Figure 12 shows the absolute change in stock price percentage for the 13 banks from year-end 2007 to year-end 2009. The only bank among the 13 to not cut its dividend during this time was Northern Trust Corporation (NTRS). Banks that cut dividends in 2008 (e.g., KEY, RF, FITB) tended to have much steeper price drops than those that cut in 2009 (e.g., WFC, USB, JPM). A strong case can be made that banks that cut their dividends in 2009, in fact, did not need to do so, but likely did in response to regulatory pressure. (See Chapter 9, “Buffett’s Two Favorite Banks,” in my book, Investing in Banks.)
A case may be made that dividend cuts are already priced into bank stock prices. Figure 13 shows the dramatic drop in stock prices for the 13 large banks from the prior two charts. The average bank in this group shows a decline in stock price of -39%. (In contrast, the S&P 500 is down -3% YTD as of April 23.)
Conclusion: What I Expect
Let me preface my conclusion by saying that I believe the United States is blessed today to have the finest generation of bank executives in the nation’s history. Many of this generation of top bank CEOs have at least a decade of experience in their position. The Great Panic of 2008-09 helped to prepare them for today’s crisis, a time that will require wisdom on not only the part of bankers but regulators and politicians.
While the Dodd-Frank legislation led to many unintended consequences, its most lasting impact is the creation of the Stress Test. Overseen by the Federal Reserve, the Stress Test equips both bank supervisors and bank executives to have a game plan for addressing a time like the one we find ourselves in. I am confident that the Fed together with the OCC and FDIC will show the measured judgment needed for the months ahead.
I expect Jamie Dimon and CEOs of several other large banks to announce a temporary dividend cut some time during the next six weeks. When they do, they will affirm their bank’s capital and earnings strength. In so doing, bank CEOs will be rebutting any suggestion that banks need to raise equity through new shares, an action that would be much more detrimental to current shareholders than a temporary suspension of dividends.
Bank CEOs will likely speak to the need for shared sacrifice at a time when 26 million (and still counting) of the nation’s bank customers lost jobs and cannot pay back—at this time—their loans. As banks need to forebear on collecting interest and principal, so too will bank owners need to forebear on collecting dividends.
Of course, bank CEOs will act in tight coordination with bank regulators and the Trump White House. Expect the US Treasury and Federal Reserve to announce a plan to give banks further temporary relief from critical capital and earnings ratios that would normally trigger aggressive regulatory action.
Restoration of bank dividends is likely dependent on a full rebound of the US economy. At present it seems a full rebound will only be possible when either a Covid-19 vaccine is available or “herd immunity” is achieved.
Further complicating the timing of the restoration of bank dividends are the political uncertainties that will not be answered until November. Regardless of which party prevails in November, bank investors are best served if banks are viewed as part of the solution to the Covid-19 Crisis, not part of the problem.
Finally, do not expect all US banks to cut dividends during the Covid-19 Crisis. While larger banks are more likely to reduce or eliminate dividends during the next several quarters, smaller, well-capitalized banks with strong credit performance should be able to preserve current dividends.
Disclosure: I am/we are long JPM, CBSH, SIVB, BMRC, SRCE, HBAN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As a former Bank of America employee, I have material financial interests in BAC.