The real winner in last week's bank stress tests should have been the shareholders.
But after the stress test results on 19 top financial institutions were announced last week and all but four of them passed, shareholders with bank dividends were left wanting more.
Of course, the more successful banks – like JPMorgan Chase & Co. (NYSE: JPM) – did announce modest dividend increases, and large share repurchases immediately afterwards.
The problem is they didn't go far enough.
Even now, after these increases, bank dividends still remain far below the level of 2007 in many cases, and represent only around a quarter of net income.
For bank shareholders, that makes no sense.
I'll tell you why.
The Case for Higher Bank Dividends
The great majority of bank shares in the United States are commercial banks, which take deposits from customers and lend money to businesses.
That is an intrinsically low-risk business, unless the bank is lending recklessly.
In addition banks provide credit card and other services to consumers and businesses, all of which are relatively low in risk.
They are also slow-growth, since the U.S. economy grows only 2-3% per annum on average. Being slow-growth, low-risk businesses, banks do not need to grow their capital rapidly.
Of course, bank services did grow faster than the economy from 1980-2007, but that is every reason to think that was something of bubble, and that much of the excess returns available to banks in those years is now gradually washing out of the system.
As a result, banks can afford to pay a high percentage of their earnings in dividends – perhaps as high as 70-80%.
Of course, recessions do happen, and banks should build up capital in good times to meet any downturns. But again, since the business is low-risk, the capital build-up can be modest.
That's why bank dividends should be at least two-thirds of earnings for shareholders to get a fair share.
However, that's not the way the big banks currently see it.
Of the banks that increased their dividends, all of them fell miserably short of that goal. They include:
- JPMorgan's (NYSE: JPM) new 30-cent dividend, which is 27% of 2011 earnings.
- Wells Fargo's (NYSE: WFC) new dividend, up from 12 cents to 22 cents, will be 31% of 2011 earnings.
- State Street's (NYSE: STT) new 24-cent dividend will be 25% of 2011 earnings.
- U.S. Bancorp's (NYSE:USB) 19.5-cent dividend will be 32% of 2011 earnings.
- BB&T Bank (NYSE:BBT) raised its dividend to 20 cents, a rather more satisfactory 44% of 2011 earnings.
What's more, all these banks' dividends except State Street are well below the levels paid in 2007.
What's Wrong with Bank Buybacks
This is not caution on the bankers' part.
All these banks except BB&T combined their meager dividend payouts with gigantic share repurchase programs.
These buyback programs are generally a generous multiple of their dividend payouts. In JPMorgan's case, for example, the $15 billion share repurchase program is more than three times the annual dividend payout.
There are three problems with these share repurchases.
First, compared to a dividend, they are a better deal for management with stock options.
In this case, a dividend reduces the assets in the company, and is thus detrimental to option holders. Whereas a repurchase raises the share price (perhaps) and thus benefits options holders.
That benefit has to come from somewhere, and it normally comes from the pockets of small shareholders, who generally are not involved in share repurchases – unless the company does a direct tender offer to all shareholders, which is rare.
Second, if share repurchases are undertaken when the shares are trading above book value, they dilute net asset value per share, and hence may lower rather than raise the share price.
For instance, let's assume that the bank has 100 shares with a net asset value of $1 per share. If shares are trading at $2, its price is two-times net asset value.
However, if the bank uses $40 to repurchase 20 shares and is left with 80 shares outstanding, its net assets fall to $60 or 75 cents/share. In the process, those same $2 shares now trade at 2.7-times net asset value. Needless to say, that is a loser for shareholders.
Third, management is generally lousy at guessing when to repurchase, and usually do so when times are good.
Conversely, when an emergency like the one in 2009 hits and banks need to issue shares at much lower prices, the shareholders take an even bigger loss since the management bought high.
How to Really Reward Bank Shareholders
Instead, all of those funds and more should go towards higher bank dividends.
For instance, If JPMorgan paid out two-thirds of 2011 earnings, it would pay a dividend of 74 cents, not 30 cents, and its shares would yield 6.8%.
And if Wells Fargo did the same, it would pay 47 cents, not 22 cents, and its shares would yield 5.6%.
Needless to say, if that was the case JPM and WFC shares would be much more attractive with those yields, and so their share prices would rise.
Even the idiots in management would benefit!
For new shareholders, in terms of the current payout decisions, you may want to consider an investment in BBT. With its new dividend, BBT still yields only 2.6%, but it is at a premium of 22% to book value and a forward P/E of 10.8.
By comparison, BBT represents better value than its peers.
These are intrinsically higher-risk businesses, which make poor investments because their management sucks out all the profits, leaving little for shareholders who bear all the risk.
As for commercial banks, their shareholders deserved better in the wake of the stress tests.
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