Back From the Brink, Banks Must Use Caution

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Includes: BAC, C, JPM, USB, WFC
by: Dr. James V. Baker

The financial media is awash with speculation about major bank holding companies increasing dividends and/or buying back shares. While regulatory authorities have acknowledged that bank balance sheets are healing, those same regulators need to remember how difficult it was to raise bank capital within the past few years. Similarly, bank holding company board members need to carefully balance the care and feeding of shareholders with the need to re-establish sound dividend policies that will not have to be reversed.

An overly aggressive dividend policy runs a serious risk of financial embarrassment in the event that a dividend has to be cut in the future. A better option would be for a bank holding company to pay modest quarterly dividends and then augment them with a year-end extra dividend based on the full year results.

A review of the financials for Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) for the period from 2005 through the third quarter of 2010 suggests that none of them are strong enough to buy back shares. They all remain highly levered financial institutions that have benefited from a period of artificially low interest rates.

These five bank holding companies have significant amounts of goodwill on their balance sheets as a result of acquisitions and accounting treatments accorded by U.S. GAAP. Goodwill represents the excess of the purchase price of an acquired entity over the fair value amounts assigned to assets acquired and liabilities assumed. Even though goodwill must be tested for impairment every year, its true value is very questionable and excluded from tangible common equity and Tier 1 capital calculations.

As of September 30, 2010, goodwill accounted for 35.60% of Bank of America’s common equity, 32.21% of U.S. Bancorp’s, 29.35% of JP Morgan’s, 21.35% of Wells Fargo’s, and 15.65% of Citigroup’s. Given the significant amounts of goodwill, the degree of financial leverage among the five aforementioned bank holding companies was gauged by reducing their common equity by goodwill and then expressing that more tangible amount as a percentage of total assets. This methodological approach revealed that Wells Fargo had the lowest degree of financial leverage at 7.49%, while JP Morgan had the highest at 5.48%. In between were Citigroup at 7.01%, U.S. Bancorp at 6.53% and Bank of America at 5.85%.

This brief analysis strongly suggests that it would be folly for the major bank holding companies to buy back shares of their common stock and/or establish large dividend payouts so soon after perching on the financial abyss. The general public, as well as shareholders, would be better served by these companies using their earnings to support loan growth. This generation of bankers needs to understand that the public’s appetite for bailing out banks has been satiated for the foreseeable future. Banks must therefore be operated with more common equity and less financial leverage.