Are your bank’s stock dividends safe? Stress test results put pressure on future payments

As you can see in the table below, Wells Fargo & Co.

WFC

it appears to be at greater risk of a dividend reduction among the “big six” US banks.

The Fed announced measures to ensure banks maintain their capital strength, but a member of the Federal Reserve Board publicly said the measures were not strong enough.

Under the severely adverse economic scenario used in the stress tests, the unemployment rate in the United States would peak at 10% in the third quarter of 2021. Given that the unemployment rate in the United States had already risen to 14.7% in April (improving to 13.3% in May), it was obvious that the COVID-19 outbreak had to be considered.

The sensitivity analysis included three scenarios of economic recovery, with a peak in unemployment at levels ranging from 15.6% to 19.5%. The good news, according to the Federal Reserve’s Vice President for Supervision, Randal Quarles, was that “the banking system is still well capitalized even in the most adverse scenarios, which are very tough.” He also said that banks should “resubmit and update their capital plans later this year to reflect current tensions.”

Here is the full statement from Quarles.

Strut capital – then back off a bit

The largest US banks have already suspended their share buyback programs, but the Fed said these suspensions were now necessary for banks under stress testing. Quarles also said that “banks will be prohibited from increasing their dividends and will be limited in their dividend payments based on recent income.

In its summary of coronavirus sensitivity analyzes, the Fed said third-quarter dividend payments “could not exceed an amount equal to the company’s average net income for the previous four calendar quarters.” That is much less strict than looking only at the first and second quarters of 2020, which have been hit hard by the COVID-19 outbreak and the incredible rise in unemployment.

Banks’ first-quarter earnings declined due to higher provisions for loan loss reserves, in anticipation of loans being depleted during the coronavirus recession. At the same time, the “Big Six” US banks have seen an increase in listing and subscription revenue, so there are plenty of moving parts. Using consensus estimates for FactSet’s second-quarter earnings and reported cash dividends paid on common and preferred shares, here is a comparison of the four-quarter averages of estimated earnings and the first-quarter dividends paid:

Only Wells Fargo paid cash dividends during the first quarter that exceeded its estimated four-quarter average of net income through the second quarter. There are many unknowns. For example, second-quarter loan loss provisions may be less than expected.

But from the previous numbers, it appears that third-quarter dividends probably won’t change from the second quarter, except possibly for Wells Fargo.

In a report released Friday, Jefferies stock analyst Ken Usdin wrote that Wells Fargo “remains the bank that seems closest to the line in terms of having the highest risk of reducing its dividend (to some extent)” .

Oppenheimer CEO Chris Kotowski wrote in a Friday note that for the banking industry, dividend payments will be a “quarterly decision,” except for Wells Fargo, “where there is a clear dividend risk for idiosyncratic problems. ” Wells Fargo operates under a consent order with the Fed that the bank must continue to improve its corporate governance and limit asset growth.

According to James Shanahan, financial services analyst at Edward Jones, share buybacks made up 75% of capital returns (buybacks and dividends) for the eight largest banks in the US during 2018 and 2019.

“The voluntary suspension of buybacks from banks in mid-March until the second quarter was already much more impactful for the preservation of capital,” he said in an interview.

Banks will make their capital plan announcements on Monday, June 29, after market close.

Fed Brainard says to suspend dividend payments

Lael Brainard, a member of the Federal Reserve Board of Governors, said in a statement that the banks’ strong capital buffers allowed them “to play a constructive role in the response to the COVID-19 pandemic.” But she is against giving the “green light for big banks to deplete capital” and believes it is time to suspend dividend payments entirely.

Profits increase capital and profits decrease as credit losses increase. Stock repurchases and dividends reduce capital. Banks under stress tests must suspend buybacks. But according to Brainard, allowing dividend payments now “increases the risk” that banks “will need to adjust credit or rebuild capital during recovery.”

“Rebuilding capital”, if necessary, would probably mean that banks would dilute the ownership interests of current shareholders by selling more shares to the public.

“The temporary suspension of payments to shareholders in large banks due to the COVID-19 shock would create a level playing field and allow all banks to preserve capital without suffering a competitive disadvantage relative to their peers,” Brainard said.

Waiting for October

Christopher Marinac, research director for Janney Montgomery Scott, said in an interview that the Federal Reserve’s decision to “give banks some flexibility” on dividends made sense, because regulators need more data on the effect of payouts on loans and other modifications to earnings.

“Tolerances and deferrals are the biggest problem the industry has at the moment,” he said. Even when banks report their second quarter results in July, information on the effect of loan deferrals will not be complete. When banks submit their quarterly 10-Q reports in early August, there will be updates on the loan modification status in late July.

Marinac called the banks “a store of value,” saying they were leading the pandemic relief effort, in contrast to their position in the 2008 credit crisis, when they were “part of the problem.” Banks were well prepared for the current crisis, “with less leverage, more capital, and less concentration” of credit risk, he said.

Looking ahead, the consensus among analysts is for big banks’ profits to improve. “If we don’t achieve that reduction in loss costs that analysts forecast, the estimates are too high and dividends could be at risk for many more banks,” Shanahan said.

Odeon Capital senior research analyst Richard Bove took a negative tone and wrote in a note to clients on June 26 that the actions of the Federal Reserve indicate that “several banks must dramatically reduce their payments.”

Bove said six banks “may unilaterally choose to cut their dividends due to their low scores on one of the Fed-administered stress tests,” including Ally Financial Inc.

ALLY

,
Capital One Financial Corp.

COF

,
Goldman Sachs

GS

,
Citizens Financial Group Inc.

CFG

,
Regions Financial Corp.

RF

and Truist Financial Corp.

TFC

.