Last week, the Federal Reserve announced that it would be restricting dividend payments for big banks after conducting the 2020 version of its stress test. Not only will banks not be allowed to increase their dividends for the time being, but the payment of any dividend is dependent on a four-quarter average of each bank's net income.
Many of the big bank stocks have already announced plans to keep their dividends at current levels in the third quarter -- including Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), and Citigroup (NYSE:C). However, the remaining member of the "big four" -- Wells Fargo (NYSE:WFC) -- didn't exactly give income investors good news.
Wells Fargo's dividend cut -- what we know
Wells Fargo will pay a reduced dividend in the third quarter. We don't yet know how much it will be, and the bank is likely waiting to see how its second-quarter earnings come out before making that determination.
As almost exclusively a commercial bank (as opposed to an investment bank), Wells Fargo is setting aside more than most in anticipation of loan losses related to the pandemic. In the first quarter, Wells Fargo built its reserves by $3.1 billion, which caused earnings to fall by $0.73 to just $0.01 per share.
CEO Charles Scharf recently said, "We expect our second-quarter results will include an increase in the allowance for credit losses substantially higher than the increase in the first quarter." If this is the case, it's likely that it will push Wells Fargo's net income into negative territory. Since the Fed's dividend rule is based on the previous four quarters of earnings, it's not difficult to see why a cut to the $0.51-per-share quarterly dividend will be necessary.
For reference, the bank's per-share earnings in the third and fourth quarters of 2019 were $0.92 and $0.60, respectively. So, unless the bank's reserve build is astronomically large in the second quarter, it will still have a positive four-quarter average earnings per share and will therefore be able to pay some level of dividend.
Should investors be worried?
First off, keep in mind that the stress tests used by the Federal Reserve are designed to test a worst-case scenario, and even in the worst COVID-19 recession tested, Wells Fargo remained adequately capitalized. However, because of the bank's massive loss reserve build in the first quarter, and the expected further build in the second, it looks like net income will be under pressure to the point where maintaining the current dividend won't be possible under the Fed's rule.
Second, this is likely to be a temporary cut, and one that still results in a pretty impressive dividend yield. At the current share price, Wells Fargo yields roughly 8%, so even if it is forced to cut its dividend in half, it will still be a relatively high-paying dividend stock.
The bottom line is that while this is certainly a disappointment to income investors, there's no reason to worry about Wells Fargo as a business. This is not the Great Recession, and the bank has more than enough capital to make it through the tough times.