Canadian Banks Should Follow Dividend Cut Trend

I know that some of you are more keen that others on this stuff (see prior representative post “Deja Vu with a Cobalt hue” December 15-08). Here is a Tweet I did on Twitter on February 23rd:

“If Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) dividends get cut in half (which I don’t expect) they’ll still be yielding 6% and 4% respectively. Still higher than last yr!”

And this from a column in the DTM on March 7th:

“Plus, even if all of Canada’s Big Banks did cut their dividends in half, their dividend yields would merely fall back to where they were in mid-2008….”

In the wake of the dividend cut at Wells Fargo (WFC) I’ve been thinking about what would happen to Canadian bank or insurance stocks if they were to follow the same course of action.

For all of the focus on high dividend rates at Bank of Montreal and ScotiaBank, Manulife is yielding 10.2% while SunLife is at 8.9%.

You have to wonder if high payout ratios are going to become a competitive disadvantage for the Canadian financial services industry. According to a Bloomberg story, Wells Fargo and the rest of the Big 5 American banks that received TARP funds were pressured by regulators to cut their dividends. Whether it be for optics or life preservation reasons, it makes sense in hindsight.

Rationale for a cut

Do Canadian Banks and Life co's need to pay 7%, 8%, 9% or 10% dividends to keep us hanging around? With bank preferred shares being issued at higher than 5% yield these days, you might suggest that the common shareholders deserve more than that given their capital structure ranking… But since prefs have always paid a bit higher yield than commons and don’t provide any real opportunity for capital appreciation that argument doesn’t hold water.

The question of a dividend cut in Canada is all about message management. What’s the rationale, can you get that point across to the marketplace, and will they believe it?

Solvency? Lowering the cost of capital at the bank? Removing the need to issue more common/pref equity or Tier 2 capital for the rest of the year? The regulator made us do it?

I’m not sure that financial services shareholders NEED a high payout to hold the various shares. The flipside is that many of these securities are held by retired people who live off the income. Not a percentage but the actual cash payout; the fact that bank dividends have been raised for years (well ahead of inflation) removes some guilt here.

Who should do it

If you are nervous about the chance of a depression, you might actually want the banks and life co's to keep their free cash flow to themselves to hopefully ensure they stay in business. As much as “higher is better” as Wardo used to say about i-banking bonuses, the time has come for Finance Minister Jim Flaherty, Bank of Canada Governor Mark Carney or OFSI Head Julie Dickson to send up a trial balloon about dividend cuts being a good idea. Portray it not as a solvency issue but one of competitive disadvantage; if other global banks are paying out dividends of 1% or less, Canadian banks would be ill-advised to be as off-market as they currently are.

For my money I’d choose the OFSI Head for the role: This shouldn’t become a political issue, but CEOs of the big 7 financial institutions are in a terrible “Prisoners’ Dilemma” situation right now. No one wants to be the first. Our regulators should take the lid off the kettle and let some of this pent up steam blow off.

Things aren’t getting any better in the world economy. The health of our financial system has helped us avoid some of the pain they are experiencing in the USA. Let’s preserve what’s working.

The time has come to give the backbone of our economy some political cover and call for a reduction in dividends.

Disclosure: We own BMO, BNS and TD in our household.

Comments

[Chezfrederick:]

The reason Canadian Banks are a model of banking for the world, is that they have not adopted the herd mentality and followed blindly the path of most other banks. As such, monkey see, monkey do is not a sufficient rationale for cutting dividends.

I believe the market has punished them harshley in an unwarranted fashion, and will come to realize there is value backed by a strong balance sheet justifying a bounce in their stock prices in the near term. As you may recall, their recently announced results were substantially ahead of analyst concensus, and looks solid going forward. Their reserves have been built up, and can provide a good profit bounce when time comes to reverse such unused portions.

Let's celebrate the difference and success, stop the pessimism, encourage solid market participants, rather than pile up the pressure with no justification.

I would be first in line to dump my holding should dividends get cut, as it would signal to me, that their financial problems run deeper than has been previously indicated.

Let's not just blow away their unique position and long lived tradition every time the winds temporarily change direction. Think long term, think respect, think confidence.

Mar 09 07:20 AM

[Columbo:]

Cutting the rate of dividend would be completely foolish. It might even lead to the bank becoming insolvent. Many of the investors - myself included who recently purchased over $100,000 of BMO and RY and MFL are purchasing because one we believe these banks which are among the best in the world are undervalued and will see significant upside and two because of the outstanding buying opportunity around the dividend.

Cut the dividend and I would cut my losses fast to pick up the stock at a lower price.

If the banks cut the dividend that would be lighting a match and dropping it on the floor covered in gasoline.

People will get burned and most likely the bank will burn down!

Mar 09 08:05 AM

[oriocookie9:]

about time i read something (hte comments to the article)that makes sense as opposed to being in "fashion" .... if the canadian banks need to cut dividends to weahter the storm then by all means they should do so.... but they have great results especially in light of current crisis and seem well positioned to go forward ... no need yet for dividend cuts .... and lets face it hording excess capital is not what a business is all about .... better distribut it to the shareholders as it was originally intended to....

Mar 09 08:46 AM

[Chris Damas:]

So many people talk about bank dividend yields without very much knowledge of the operations. "Banks" are highly complex financial risk-takers as we recently found out.

Sophisticated investors see through the yields to the value of the underlying operations. Wells Fargo rallied after the cut on Friday. But JPM has declined since the initial rally after cutting their payout. But the market has also declined.

The Bank of Montreal recently reported 40 cents in cash earnings making their actual Q1 payout ratio an unsustainable 175%. But they added back charges for "unfavorable capital market environment" to come up with $1.09 a share. Then the CFO says that $1.09
should be a pretty good proxy for core earnings. Can you say the good part of the bank is "core" and the bad bets are "non-core"? Investors aren't that stupid.
A cut would probably make all the high yield dividend collectors that didn't understand the operations dump the stock.
That includes a number of "professionals".

Mar 09 12:03 PM

[True North_:]

The current recession/depression is challenging to predict. The banks will be loathe to cut their dividends, particularly when their base operations are still profitable. Certainly, none of them will want to be first. Even BMO, which has the highest yield (and whose dividend is now well outside management's expressed range), can maintain the payment level for the "predictable" future. As we have seen, however, future predictions are (to say the least) challenging to make. If the domestic (i.e., Canadian) business weakens significantly and the economic malaise extends longer than hoped (and it is all based on hope right now...), then they may not have a choice. Interesting times, to say the least.

The suggestion that cutting the dividend could lead to insolvency (Columbo, above), doesn't make much sense to me. It would make it trickier to raise common equity capital, but they've already tapped the markets in the last 6 months(and with pref share issuances). BMO cutting its dividend to (say) $0.30 - $0.40/quarter could shore up its capital quite handily, if needed. Watch second & third quarter results: if they deteriorate materially and the glimmer of recovery on the horizon remains distant, then you would do well to assume the dividend is significantly at risk.

Mar 09 05:20 PM

[oriocookie9:]

good point ... and i am sure everyone is watching results .....


On Mar 09 05:20 PM True North wrote:

> The current recession/depression is challenging to predict. The banks
> will be loathe to cut their dividends, particularly when their base
> operations are still profitable. Certainly, none of them will want
> to be first. Even BMO, which has the highest yield (and whose dividend
> is now well outside management's expressed range), can maintain the
> payment level for the "predictable" future. As we have seen, however,
> future predictions are (to say the least) challenging to make. If
> the domestic (i.e., Canadian) business weakens significantly and
> the economic malaise extends longer than hoped (and it is all based
> on hope right now...), then they may not have a choice. Interesting
> times, to say the least.
>
> The suggestion that cutting the dividend could lead to insolvency
> (Columbo, above), doesn't make much sense to me. It would make it
> trickier to raise common equity capital, but they've already tapped
> the markets in the last 6 months(and with pref share issuances).
> BMO cutting its dividend to (say) $0.30 - $0.40/quarter could shore
> up its capital quite handily, if needed. Watch second & third
> quarter results: if they deteriorate materially and the glimmer of
> recovery on the horizon remains distant, then you would do well to
> assume the dividend is significantly at risk.

Mar 10 01:12 AM