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Wells Fargo Expects to Cut Q3 Dividend Following Fed's Stress Test

The Federal Reserve released the results of its 2020 stress test last Thursday, providing the first look at how regulators are assessing the ability of America's largest banks to withstand the coronavirus.

The good news is that all 33 of the banks subject to the Fed's test were projected to remain above minimum regulatory capital requirements under each scenario, including V-, U- and W-shaped economic recoveries.

In other words, the biggest banks (including Wells Fargo) appear well positioned to survive most financial storms caused by the pandemic without needing to raise more capital.

Dividends, which reduce the amount of capital banks retain, were also allowed to continue but with some important caveats.

Through at least the third quarter, the Fed said dividends cannot be increased or exceed an amount equal to the average of the firm's net income for the four preceding quarters.

While we don't believe this will threaten other big banks' payouts (JPMorgan and several others already announced plans to maintain dividends), this is problematic for Wells Fargo.

Analysts currently project the firm will generate $1.33 per share in earnings over the next year, less than its $2.04 per share dividend.

In response to the Fed's new guidance for dividends, Wells Fargo stated this evening that it expects to reduce its dividend in the third quarter, with the new amount to be announced when the firm releases its earnings results on July 14.

When discussing Wells Fargo's Unsafe Dividend Safety Score in May, we raised concerns about the bank's dividend coverage:

Wells Fargo could be in a particularly tough spot due to its asset cap (harder to generate more income when you can't lend more and fees are being reduced to help distressed customers) and potential need to substantially increase its provision for credit losses. 

If management or regulators believe these factors will suppress the bank's earnings power for the foreseeable future, then it's possible the dividend will need to be lowered.

Unfortunately, some of these risks have played out. Besides the Fed's more conservative stance, Wells Fargo said it has changed its economic assumptions since last quarter to incorporate a weaker outlook.

As a result, its results next quarter "will include an increase in the allowance for credit losses substantially higher than the increase in the first quarter," further reducing the firm's net income.

Given the Fed's new guidance that caps dividends, a steeper drop in earnings will lower the amount of capital Wells Fargo can return to shareholders next quarter.

If Wells Fargo reduced its dividend to match its average trailing earnings through the end of June, we estimate the bank may need to lower its payout by only around 10% to 20%.

However, management may desire a more conservative approach to avoid additional dividend cuts since earnings are expected to continue falling and the dividend cap could extend well beyond the third quarter.

Based on the Fed's guidance, analysts' EPS estimates, and Wells Fargo's expected increase in allowance for loan losses, we wouldn't be surprised if the dividend was reduced by at least 30% to 50%.

Using Wells Fargo's closing stock price as of June 29, that would result in a pro forma dividend yield between 4% and 5.5% (at best).

Looking ahead, expectations continue to appear low for Wells Fargo and other bank stocks.

But that may not change until investors have more clarity on the depth and duration of this recession, which will drive key earnings drivers such as loan loss rates and long-term interest rates.

Current shareholders should gauge if they are willing to deal with this industry's complexities (opaque balance sheets, high dependence on uncontrollable factors, etc.) and the lingering overhangs from COVID-19 which could persist for several quarters or much longer.

Wells Fargo and the largest U.S. banks still maintain solid capital positions based on the Fed's stress test, but the credit environment seems likely to get worse before it gets better. The question is how much worse, and for how long.

We will continue monitoring the situation and its impact on dividends across the industry. Should the outlook significantly deteriorate, other big banks (most are rated Borderline Safe) may need to join Wells Fargo and reduce their dividends. 

Like the Fed's guidance, all investors can do for now is take one quarter at a time.

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