Wells Fargo & Company (WFC) announced a deep dividend cut this past week. The cut was a whopping 80% due in lower income in the most recent quarter. Notably, the U.S. Federal Reserve has limited dividends by the big banks, which includes Wells Fargo. This main reason was to maintain adequate capital levels during the pandemic. Wells Fargo also boosted its credit loss reserves by $8.4 billion in response to the current economic downturn caused by COVID-19. Although the dividend cut was deep and arguably necessary, it does put Wells Fargo in a stronger position for the economic downturn. Cash flow requirements for the dividend will be substantially reduced going forward. Let’s take a look at the dividend cut in greater detail.
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Overview of Wells Fargo & Company
Wells Fargo was founded in 1852 in California. Today, Wells Fargo is one the largest banks in the U.S. based on assets. The bank had $1,763,696,000,000 in assets at the end of June 2020. This made it the third largest bank in the U.S. Wells Fargo has three reporting segments: Community Banking, Wholesale Banking, and Wealth and Investment Management. Community banking offers retail banking including checking and savings accounts, credit cards, car loans, mortgages, etc. Wholesale Banking provides commercial banking services. Wealth and Investment Management provides wealth management, retirement accounts, private banking, financial planning, etc. Wells Fargo has roughly 7,400 locations including 13,000 ATMs worldwide. Revenue was $85,135 million in 2019.
Wells Fargo – Deep Dividend Cut
Wells Fargo announced a deep dividend cut when reporting Q2 2020 earnings. The quarterly regular cash dividend on the common stocks was slashed by approximately 80% from $0.51 per share to $0.10 per share. The cut will take place for Q3 2020. The annual dividend yield was roughly 8% before the cut. At the new dividend rate, the annual forward dividend yield is about 1.6%. However, the dividend is likely more sustainable at this new lower level.
Specifically, the company Chief Executive Officer or CEO stated:
We are extremely disappointed in both our second quarter results and our intent to reduce our dividend. Our view of the length and severity of the economic downturn has deteriorated considerably from the assumptions used last quarter, which drove the $8.4 billion addition to our credit loss reserve in the second quarter. While the negative impact of the pandemic is unprecedented and many of our business drivers were negatively impacted, our franchise should perform better, and we will make changes to improve our performance regardless of the operating environment.
He also added,
Though our income performance was weak, our capital and liquidity continues to be extremely strong with both our CET1 ratio and LCR increasing from the end of the prior quarter. However, it is critical in these uncertain times that our common stock dividend reflects current earnings capacity assuming a continued difficult operating environment, evolving regulatory guidance, and protects our capital position if economic conditions were to further deteriorate. Given this, we believe it is prudent to be extremely cautious until we see a clear path to broad economic improvement. We are confident that this eventual economic improvement combined with our actions to increase our margins will support a higher dividend in the future.
There are really two main points here. First, the bank’s earnings are being impacted by COVID-19. There are multiple aspects to this as I discuss below. Second, regulatory and capital position requirements are limiting the bank’s ability to pay dividends.
Impact of COVID-19 on Wells Fargo
Wells Fargo reported Q2 2020 results on July 14, 2020. It did not make for good reading. The bank had a quarterly net loss of $2.4 billion, which included an $8.4 billion increase in credit loss reserves. This is not a small amount. Net income was about $6.2 billion in Q2 2019 and $0.65B in Q1 2020.
Wells Fargo is being hit with lower income and higher expenses due to COVID-19. Net interest income was approximately $9.9 billion, down by $2.2 billion in the prior year. Noninterest income was approximately $8.0 billion, down by $1.5 billion in comparable periods. The bank had an additional $382 million in expenses related to COVID-19. Further, there was about $295 million in fee and interest waivers to customers during the pandemic.
The dollar amount of loans is declining due to COVID-19. Period-end loans were $1,009.8 billion at end of Q1 2020. This was down to $935.2 billion at end of Q2 2020. This decrease was driven by declines in commercial and industrial loans, consumer real estate loans, credit card loans offset by an increase in commercial real estate loans and auto loans. But the overall trends are not good. Demand for loans and spending on credit cards will likely be lower going forward due to the COVID-19 pandemic.
Long Term Trends Are Not Good
The fact that Wells Fargo has lower interest income is not surprising. Interest rates have come down quite a bit since early 2019. In turn this has resulted in declining total average loan yield and net interest margin for Wells Fargo. This has occurred despite higher average loans outstanding. Take a look at the chart below for net interest income. The average loans outstanding were $947.5 billion in Q2 2019 and it was $971.3 billion in Q2 2020. On the other hand, the total average loan yield was 4.8% in Q2 2019 and it was 130 bps lower at 3.5% in Q2 2020. Similarly, net interest margin dropped from 2.82% to 2.25% in the same time period. It’s no wonder that the bank has lower interest income.
Similarly, noninterest income has declined from 2019. This is due to lower service charges, trust and investment fees, card fees, etc. On a positive note, there has been an increase in income from trading though.
Regulatory Requirements and Capital Position
The U.S. Federal Reserve conducted so-called stress tests of the largest banks in June 2020. The Fed evaluated different scenarios in response to COVID-19. The result was that the Fed suspended share repurchases and limited dividends by banks. Specifically, the dividend payouts will be tied to a formula based on the average net income over the past four quarters. Note that one member of the Fed dissented and instead wanted a blanket suspension of dividends. The Fed will proceed on a quarter-by-quarter basis. It is difficult to foresee what the Fed will do for the next few quarters. But clearly, big bank dividends and share repurchases will be scrutinized relative to the state of the economy and the evolving impact of COVID-19. I view it as unlikely that the dividend will return to normal in 2020.
When Will Wells Fargo’s Dividend Be Increased Again?
The dividend cut by Wells Fargo was deep. However, it is not clear when Wells Fargo will be able to raise the dividend again. Wells Fargo’s strength is community banking and the home mortgage market, where it is a large player. However, this means that Wells Fargo’s income is sensitive to interest rates. The above statements from the bank indicate that any future dividend increases are tied to an increase in the net interest margin. In turn this is tied to an improvement in the U.S. economy and also to the Fed raising the Federal Funds Rate. Until that time, it is likely that total average loan yield and net interest margin will remain depressed.
That said, Wells Fargo increased the dividend relatively aggressively after the sub-prime mortgage crisis in 2008 – 2009. I expect that the bank will follow a similar path once the economy is on more stable footing.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.