For decades, dividend investors could rely on bank stocks to provide steady and increasing dividend streams without the drama that was often associated with other industries. Banks were, at that time, anyway, pretty boring businesses. They offered industry services like bank and checking accounts, and used that money to lend to homebuyers and business owners.
In the “good old days,” banking was a relationship business. You knew your banker and your banker knew you. Perhaps more importantly, your banker also knew the person to whom money had been lent. Moreover, the loan officer was responsible for all of the loans he or she made, so a great deal of care was taken to ensure that loans were given to creditworthy individuals and businesses. (If a loan went bad, a person’s job was at stake.)
However, as the saying goes, that was then and this is now. Regulations in the banking industry were softened over the years, financial “engineering” gained prominence, and risk taking exploded. Leading up to the financial crisis that helped to cause the 2007-2009 recession, banking had almost become a numbers game. Get as many customers to make deposits, it didn’t matter who they were, and then lend that money out as fast as possible. The loans would then be sold off, bunched together in mortgage bonds—so it didn’t matter who got a loan, either.
Although it should have been obvious that this business model had flaws, the money was just too good and seemingly too easy. The entire country jumped aboard the train and the whole country felt it when the train crashed. One group particularly hard hit, on a financial and emotional level, was the conservative dividend investor. What were once considered widow and orphan stocks that could be counted on in good times and bad to pay a steady, and usually increasing, dividend had been unknowingly transformed into risky bets. The ride up was enjoyable, but the ride down hurt—and it shattered long held beliefs.
Dividends were cut to the bone or completely eliminated at some of the largest and once most proud banking names. Smaller banks were shuttered, in an orderly fashion, by the government. Struggling larger banks were merged away into stronger, at least on a relative basis, banks. But perhaps most disturbing, the government felt that it had to step in and provided a financial backstop that has yet to be fully removed. It’s no wonder that many dividend investors feel betrayed.
In the years since the 2007-2009 financial crisis, some banks have started to rebuild the trust of the investing public, and dividend investors, in particular. Indeed, many banks that slashed their dividend have begun increasing them again. Although most have not restored their dividends to where they were before the crisis, the trend has been, by and large, in the right direction—if slower than investors would hope.
Then, after the market close on Thursday May 10, Dow-30 component and banking industry behemoth J.P. Morgan Chase (JPM - Free J.P. Morgan Chase Stock Report) announced a trade had gone awry to the tune of $2 billion. (Read more about the J.P. Morgan Chase announcement.) Although this is only one company, from a dividend investor’s perspective, it looks like the banking industry has again taken risk taking too far. The basic trust that so many in the industry have worked so hard to rebuild has been shaken—and, unfortunately, by the nation’s pre-eminent lending institution.
Does this mean that all banking stocks should be jettisoned? No, it does not. However, it does mean that dividend investors need to take a very close look at what they are buying. While once bigger was better, investors might find fewer surprises by going small. For example, Texas-based Cullen/Frost Bankers (CFR) managed to sidestep most of the financial crisis and actually increased its dividend payments, while others were cutting.
So, despite J.P. Morgan Chase’s “bomb,” there are still some nuggets of gold in the banking sector. Dividend investors just need to be careful to take their time when making selections so that they don’t wind up with fool’s gold. A good place to start is by reading Value Line Banking Specialist Terry Brophy’s article Getting to Know a Bank with Financial Ratios.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.