For and Against Banks Cutting Their Dividends

Jim Sinegal in Morningstar argues in favor of banks' cutting their dividend payments, while Morningstar Dividend Investor editor Josh Peters takes the opposing stance. For the likes of Citigroup (C), Wachovia (WB) and Huntington Bancshares (HBAN), maintaining high dividend payments may simply no longer be an option, but what choice do the likes of Wells Fargo (WFC), US Bancorp (USB) and Bank of America (BAC) face?

Sinegal believes that there are preferred alternatives to paying large dividends in today's climate, including share buybacks and knock-down bargains on distressed assets.

When faced with a choice between returning cash to shareholders or creating value by repurchasing undervalued shares, buying cheap assets, or acquiring other banks at fair prices, I'll take the additional value every time.

Even though issuing new shares is one method of building capital, diluting existing shareholders is far from the best alternative, in my opinion. Taking in capital with one hand and handing it out with the other at depressed stock prices is only good for the investment bankers getting paid to assist with the offering, and fearful market participants are currently demanding a high price for scarce capital. Dividend cuts are another way to achieve the same goal... Additionally, such a plan does not actually harm income-seeking investors. If shareholders need cash, there's always the option of selling shares in the open market. Finally, if a shareholder doesn't trust a bank's management to make optimal capital allocation decisions, there's no reason to own the common stock in the first place.

Sinegal holds out little hope that many financials would follow such advice, and he indeed recognizes that there are investors that rely on dividend payments for income. However, he concludes that "the temporary discomfort of a cut should be more than offset by the long-term benefits, in our opinion. I think there are many cases in which shareholders should be happy to receive a dose of this seemingly bitter medicine."

Josh Peters on the other hand dismisses the idea of chopping dividends for institutions with adequate capital, regarding it as "handing shareholders an unnecessary pay cut". The regulated banking system certainly needs more capital, he admits, and any bank that has elected to plow ahead with its traditional hefty dividend payments would be unable to take advantage of some of the opportunities available. But this fails to win the argument for dividend cuts. They send a clear negative signal, according to Peters:

A management team may claim that a dividend cut is meant to advance the long-term interests of shareholders, but a great many investors buy banks because they expect handsome current income. Denying their interests may create growth opportunities on paper, but if long-suffering shareholders feel betrayed, they'll likely sell their shares and pursue more reliable income elsewhere. That, in turn, will increase the bank's cost of equity capital, negating the value of additional earnings that the retained capital might generate.

He also notes that dividends allow the investor to choose whether to reinvest further in the stock, or take their investment elsewhere. Furthermore, reducing dividends is a very slow way to bolster a bank's capital. Peters argues that new equity issues are preferable, not just for the timely raising of large sums, but that it also grants the market an up-or-down vote on company management, denying ineffectual lenders the capital they seek. In conclusion, Peters argues that dividend cuts are a bad strategy:

The last thing bank investors need right now are dividend cuts. Some may be unavoidable, and these stocks should be avoided by income seekers. But the banks that can and do maintain their dividend payments--uninterrupted through this crisis--can expect to be rewarded with lower costs of capital and higher valuations once this current crisis subsides.

Comments

[User 33580]

SINegal is wacky! If his salary was slashed he would benefit by paying lower taxes so let him look at that bright prospect!!!!!!!