Wells Fargo Under Review for Sale in our Portfolios as Political Pressure Clouds Outlook for Distributions

America's largest banks have come a long ways since the 2007-09 financial crisis. Based on data from the Federal Reserve, they are well capitalized and have sizable capital buffers to absorb losses from unexpected shocks.

The Fed's 2019 stress test on the nation's largest banks such as Wells Fargo (WFC) indicated that these institutions could maintain adequate capital levels, as well as their dividends, in "severely adverse" economic conditions.

However, the coronavirus pandemic is a test unlike any other as many parts of the economy have now reached a standstill. Many households and businesses simultaneously need access to capital, and fast.

Despite their strong capital levels, America's biggest banks already suspended their share buybacks earlier this month in order to make more cash available for their communities during this crisis.

Based on our full analysis further down, it's not out of the question that regulators could next pressure some banks to temporarily suspend their dividends to free up even more capital.

It doesn't matter that their payout ratios are low and their capital levels are high. This is an unprecedented situation which could call for unprecedented action, and putting shareholder distributions before the wellbeing of the economy isn't a good political look.

Given the widening range of short-term outcomes for the economy, elevated political pressure, and the rising need for banks to provide a lot of liquidity all at once, we are downgrading Wells Fargo's Dividend Safety Score from Safe to Borderline Safe.

The stock is now under review for potential sale in our Top 20 and Conservative Retirees portfolios. We would prefer to own a company with clearer dividend visibility, and the market's selloff this month has resulted in some other ideas with similar yields to explore. 

Expectations for Wells Fargo's stock look low, reducing the urgency to act as we evaluate alternative ideas. In the unlikely event we take any action prior to publishing our next newsletter on April 3, we will send out an email.

The long-term outlook for banks arguably hasn't changed, and they remain in good financial health going into this unusual situation. It seems unlikely that this will be a repeat of 2008 for banks given their stronger capital buffers and the government's efforts to prop up hurting businesses and consumers.

Coupled with the steep decline in bank stock valuations, these new developments may not bother long-term investors who are comfortable with the industry's risk profile and the cloudier short-term outlook for shareholder distributions.

We will know a lot more over the coming weeks as efforts continue to slow the spread of the virus, and as this year's stress test deadline approaches for the largest banks. These firms must have their capital plans approved by the Fed before their proposed dividends can be paid.

Here is our broader view of the key issues facing banks and their dividends:

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The State of the U.S. Banking Industry
Since the start of the year, the S&P 500 Index has shed about 30% while bank stocks, as measured by Invesco's KBW Bank ETF (KBWB), have lost roughly 50%. 

Virtually all of the sector's decline occurred over the last month as the coronavirus pandemic sent shockwaves across global economies and financial markets.

This has created an unusual and rather discomforting situation where high dividend yields abound in the financials sector. 

Well Fargo (WFC) and a number of regional banks now sport yields around 7% to 8%. Most other financial institutions have also seen their dividend yields double into the mid-single digits.

Many bank stocks now trade below their tangible book value, too. Tangible book value is a measure of shareholder equity and usually serves as a price floor unless markets believe book value is about to take a big hit, usually from credit losses.

Following years of steady dividend growth for the banking industry, have the unprecedented events of recent weeks changed the outlook for dividend safety?

It's complicated, and the outlook has become cloudier.

We think the future of bank dividends hinges on the depth and duration of this unusual economic downturn, along with the amount of political pressure these firms will face to help households and businesses address substantial liquidity challenges before paying shareholders.

This is a very fluid situation with many unanswered questions and a wide range of potential outcomes:

What we do know is that banks entered these uncharted waters in good financial health. 

To gauge risk to the financial system, the Fed measures a bank's capital against its risk-weighted assets (a bank's loans, investments, and other assets are assigned values based on how risky they are deemed to be). 

Based on these measures, regulators require a bank to maintain minimum required capital adequacy ratios. 

Common equity tier 1 capital (CET1) is the most loss-absorbing form of capital since it primarily consists of the bank's common stock and retained earnings.

Most regional banks are required to maintain a CET1 to risk-weighted assets ratio of at least 4.5%, plus a 2.5% "capital conservation buffer" designed to strengthen an institution’s financial resilience during economic cycles.

Very large banks such as Wells Fargo are deemed by regulators to be "global systemically important banks" (GSIB). Due to their importance to the international financial system, they are assessed an additional capital surcharge usually between 2% and 4%.

JPMorgan Chase (JPM) in its 2019 annual report showed the breakdown of its minimum CET1 capital ratio requirement of 10.5%. The bank's actual ratio was 12.4%, meaning that it had $12.40 of capital for every $100 of risk-weighted assets on its balance sheet.

The CET1 ratio is important for dividend investors to understand. If a bank's capital buffer falls too low, then regulators can restrict the amount of capital a bank can return to its shareholders (if management hasn't taken such action already).

Following the 2007-09 financial crisis, global regulators implemented new standards requiring banks to hold more capital with hopes of building a more stable financial system that can withstand future shocks without requiring bailouts.

The chart below shows the U.S. banking sector's CET1 ratio from 2001 through 2017. Prior to the 2007-09 financial crisis, most institutions maintained ratios around 7% to 8% (with a plunge below 5% in 2009). Today, CET1 ratios sit near 12% for many banks.

Following the 2007-09 financial crisis, the Fed started conducting annual stress tests on the nation's largest banks to project the capital needs of each firm under adverse economic conditions. This is done to help ensure that banks could maintain much healthier capital ratios whenever the next downturn occurs.

The most severe economic scenario tested by the Fed in mid-2019 made a number of dire assumptions including:

Under this harsh scenario, last year all 18 banks and other financial institutions that faced this test still cleared the Fed's 4.5% minimum CET1 ratio requirement. Capital One (COF) came the closest to failing the test with a ratio of 6%. 

Only one other bank (Goldman Sachs) ended with a minimum CET1 ratio below 8%, and the group's average was 9.2% (more than double the minimum requirement).

The table below show's each of the 18 banks' CET1 ratios at the end of 2018, with their ending and minimum CET1 ratios from the Fed's most severe adverse economic conditions test in the other two columns.

Importantly, the Fed's stress test assumes that while a bank's share repurchases are suspended during a downturn, its regular dividend is maintained. All else equal, paying a dividend reduces the amount of capital a bank retains each year.

Since all of these institutions passed the stress test with flying colors last summer, the Fed did not object to their capital plans, which included generous dividend increases in many cases. In July 2019, Goldman Sachs raised its dividend by 47%, Wells Fargo boosted its payout by 13%, etc.

If the Fed had felt that these dividends would threaten a bank's capital buffer during a severe downturn, it would not have given the green light.

But could the coronavirus pandemic change that outlook?

That's what the market seems to be concerned about as government-mandated shutdowns intended to slow the transmission of the virus have damaged the economy overnight.

With many businesses closing their doors temporarily and furloughing workers, households and companies are hurting. Concerns have increased that some of them won't be able to meet their debt obligations, causing a spike in credit risk.

Morningstar published an article on corporate bonds last week. Credit spreads, which measure how much extra yield investors demand to hold a corporate bond rather than a risk-free Treasury of similar maturity, spiked to their highest level in at least 20 years, excluding the 2008 financial crisis.

The market appears to be concerned that the coronavirus pandemic will result in widespread bankruptcies for financially weaker malls, retailers, hotels, restaurants, and other businesses, while also causing many households to fall behind on mortgage payments, credit card debt, and other obligations.

If the coronavirus continues creating havoc despite the government's unprecedented stimulus measures, then this potential Black Swan could be the ultimate test of how well insulated banks really are.

It could also result in widespread credit rating downgrades for some of a bank's investments. This has potential to increase the amount of risk-weighted assets a firm is deemed to have, reducing its CET1 ratio if offsetting capital isn't raised.

Warren Buffett probably wasn't thinking about a pandemic when he made the following remark in a 2013 interview:

Based on how battered many of these stocks are, investors don't appear to have much faith in the Fed's stress test assumptions being conservative enough to account for an entire economy shutting down and creating many ripple effects.

This situation has even more complexities for banks due to the vast number of households and businesses being impacted. Many of them suddenly no longer have an income stream but have bills and loans coming due.

For example, what happens if the restaurant you worked at was ordered to temporary close, you were laid off, and now you don't have the money to make your mortgage payment to Wells Fargo in two weeks?

Banks have begun stepping up to help their communities in unprecedented ways. Many have announced plans to modify payment terms, waive late fees, defer certain loan payments, and suspend property foreclosures, among other measures.

Banco Santander (SAN), the largest bank in Spain, even announced it would delay its next dividend payment in order to have more funds available for businesses and individuals (even despite the bank maintaining a healthy payout ratio and solid capital levels): 

Depending on how drawn out the coronavirus crisis becomes, political pressure could mount for some of America's banks to take similar actions.

On March 15, the eight largest U.S. banks announced they would suspend share repurchases through the second quarter, demonstrating their "unquestioned ability and commitment" to support their customers, clients, and the nation.

If companies continue maxing out credit lines to hoard cash in response to coronavirus-related uncertainties and bond markets freeze, then bank credit could become an even more critical source of financing to help companies.

This is a major drain of cash, and some of the desperate businesses taking advantage of their credit revolvers may struggle paying it all back.

Coupled with falling interest rates reducing lending profits, growing concerns over future loan performance, and needing to help their communities in unusual ways, perhaps banks will feel pressure to maintain even larger capital buffers than what they have today.

Banks can pull several levers to improve their CET1 capital ratios, which again are calculated by dividing a bank's capital (common stock and equity) by its risk-adjusted assets (loans, investments, etc).

First, they could look to reduce their risk-weighted assets. However, running down loan portfolios, selling assets, and slowing lending growth are not politically acceptable in today's stressed environment.

Another option is to replace riskier loans with safer ones or investments with low-risk profiles such as Treasury bonds. However, these aren't the businesses that most desperately need capital right now.

With asset reductions out of the question (Wells Fargo even asked regulators if its asset cap could be lifted so it could lend more to communities), banks could look at issuing equity to bolster their capital position. But with shares prices trading below book value in some cases, shareholders would face costly dilution.

There's only one option left if regulators or management teams decide banks need to do more to help or prepare for an increasingly uncertain future: retain more earnings.

The easiest and fastest way for a bank to increase the money it has available to lend is to reduce or eliminate share buybacks and dividends. Billions of dollars would be freed up immediately, and every $1 of capital supports $16 of lending.

Buybacks have (at least temporarily) been eliminated by many U.S. banks already in response to the crisis. Dividends have remained intact so far, though we might not be too far into the worst of the coronavirus crisis yet. It's hard to say.

If the economic lockdown persists long enough, perhaps taxpayers will increasingly feel that banks owe the public something during these trying times.

After all, the government bailed out banks just over a decade ago, and it's not a great look showering shareholders with dividends while businesses and households struggle to make ends meet.

This backdrop will make for an interesting summer, assuming the schedule goes on as planned. All 34 of the U.S. banks with more than $100 billion in assets will be subject to the 2020 stress test, with results announced by June 30, 2020.

Banks must pass the Fed's test in order to return money to shareholders. It's unclear how recent events could impact the Fed's decision to allow banks to continue making their full payouts if political pressure rises or an unprecedented downside scenario now needs to be planned for. 

Perhaps the Fed will decide to withhold from approving banks' capital plans this year until more economic clarity is provided.

Investing in banks is complicated enough when times are good. Today, investors must grapple with uncertain political and financial pressures that have potential to interfere with dividend payouts. 

Banks appear to remain in good shape today, but the environment is evolving quickly. The fate of some of their dividends, at least in the short term, could depend on how much caution and help for the community regulators and management teams deem to be prudent.