It should be simple and brilliant. While the 10-year Treasury is paying around 3.5%, and a five-year CD is in that neighborhood, bank stocks are yielding an average of around 6%.
It's easy, just collect the dividend and wait for the banks to come back. After all, who thinks bank stocks will still be depressed in five years?
Here's the problem. Many banks with tantalizing yields have one foot on a dividend cut and the other foot on a banana peel. So, you better be very selective about which banks you buy or hold.
They'll cut like a cheap horror movie slasher
How imperiled are bank dividends? Well, dividend payouts are at their second highest level since 1990, a level that will be difficult to maintain. Dividends require extra cash that banks increasingly don't have. In fact, Donald Kohn, vice chairman at the Federal Reserve, recently suggested to the Senate Banking Committee that many banks should consider cutting their dividends to reduce strain on their balance sheets.
Banks have already begun doing precisely that. The past 12 months have set an all-time record for dividend cuts or eliminations by S&P 500 companies; most of these have been financial stocks. Many of the larger banks have high relative dividend payouts and thinning capital cushions. To use an extreme illustration, Oppenheimer analyst Meredith Whitney estimates that this year Citigroup (NYSE: C ) will earn $1.43 less per share than it pays out in dividends.
Which banks will cut?
As banks become increasingly strapped for cash, they typically first stop any stock repurchases. Then, they raise cash by issuing preferred stock. After that, they're most likely coming for the dividend.
Banks most at risk to cut are banks with high dividend payouts, that undergo large write-offs, and that have already exhausted alternatives by stopping share buy-back programs and issuing preferred stock. Analyst Kevin St. Pierre of Sanford C. Bernstein & Co. estimates that Bank of America (NYSE: BAC ) , SunTrust Banks (NYSE: STI ) and Wachovia (NYSE: WB ) are all at risk to cut dividends, because they all have yields higher than 4% and they already have large preferred stock issues outstanding.
Whitney, who made her reputation last October by accurately predicting Citigroup's dividend cut, also predicts that Citigroup, Wachovia and Wells Fargo (NYSE: WFC ) will all report weaker-than-expected earnings this spring, likely leading to dividend cuts. Both analysts feel Wachovia, with a yield of nearly 9%, is at high risk.
What looks OK?
Of course, banks are safer when the reverse is true; when they have lower relative payouts and stronger capital cushions. St. Pierre considers JPMorgan Chase (NYSE: JPM ) and Capital One (NYSE: COF ) to be among such banks.
I still love the idea of taking advantage of this environment and buying banks cheap. If you can collect a nice dividend while you wait for the price to come back, it's a beautiful thing. But, be extremely careful to be in the right banks. A dividend cut and the likely ensuing price decline can really throw a wrench in the works.