To Cut or Not to Cut: the Dividend Dilemma

When JPMorgan Chase & Co. slashed its dividend 87% in February, from 38 cents to 5 cents per quarter, it marked one of the last dividend holdouts to crumble in the face of the financial crisis. “Extraordinary times must call for extraordinary measures,” CEO Jamie Dimon said in explaining the move. JPMorgan is among the few large banks to remain profitable. Even so, an extra $5 billion a year in capital should come in handy as it fights declining loan quality.

As the crisis deepens, dividends are catching more attention from investors and regulators. Plunging bank stock share prices have made some yields look borderline ridiculous. Temecula Valley Bancorp, a $1.6 billion lender in California, recently boasted a 47% yield, but was trading in penny-stock territory and in February signed a cease-and-desist order with the Federal Deposit Insurance Corp; At a recent share price of $15, $152 billion BB&T Corp., in Winston-Salem, North Carolina, boasted a yield of 12.5%. In total, 85 publicly traded banking companies were paying out yields of 7% or more, according to SNL Financial.

More than 180 banks and thrifts have cut or suspended their dividends since the beginning of 2008, according to SNL, and more could be coming. With loan losses poised to increase in the near future and banks faced with few appealing prospects for gaining additional capital, retaining more earnings makes sense.

Regulators, charged with safeguarding the system-not shareholder rights-have encouraged it, sometimes strongly. In February, the Federal Reserve issued a guidance letter requiring banks to consult the Fed before they pay dividends that might raise “safety and soundness concerns.”

The question is, what will investors think? One of the chief historical reasons for investing in a bank is the dividend. While not flashy or high growth, the industry has long been viewed as a source of safe, solid income. Slash the dividend, the thinking goes, and it’s tough to make a case for investing in the industry at all. Bank stocks have been under intense pressure, and most slip even lower once a dividend cut is announced.

“If your asset quality is deteriorating and then you cut the dividend because it’s the ‘prudent thing to do,’ investors will think more charge-offs are coming,” says Allen Laufenberg, a managing director at investment bank Stifel Nicolaus.

It’s also true that scaling back the dividend might not do much for capital, anyway. If a bank with $100 million in equity and a 10% return on equity has a 35% payout ratio, “you’re only adding $3.5 million to your capital base if you cut the dividend to a penny,” Laufenberg says. “Is that enough to make a difference?”

“From a financial standpoint, it might make sense to preserve as much capital as possible,” says Fred Cannon, an analyst with Keefe, Bruyette & Woods. “But if a dividend cut reduces confidence in the organization, you could have more difficulty raising capital down the road.”

The flip side is, a bank that tries to prop up an unsustainable dividend isn’t fooling anyone. A yield of above 10% is the market’s way of saying that it expects the dividend to be cut, or worse, analysts say.

If your board doesn’t think it can sustain its present payout for at least four quarters, the best advice is to take your medicine soon and in one dose. “You don’t want to be the first to cut, and you don’t want to be the last. And you want to cut it enough so that you’re not doing the same thing in six months,” Laufenberg says. “You want to position yourself as, ‘We understand the economy could get worse, and we’re taking all of the necessary steps to confront it.’ Get to that base level, and then try to grow from there.”

And who knows? Investors might not react all that badly. The day after Dimon’s announcement, JPMorgan shares jumped 5%.