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By Jeremy Glaser | 03-14-2012 10:00 AM

Peters: 3 Best Banks for Dividend Investors

The Fed's stress tests confirm that Wells Fargo, U.S. Bancorp, and BB&T are the best bank bets for income investors, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. After the Federal Reserve released its latest stress-test results, many big banks announced dividend increases or share-buyback plans. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to take a closer look at these increases and see what investors can expect in the future.

Josh, thanks for joining me today.

Josh Peters: Good to be here. Always, good to be here with good news.

Glaser: So let's talk a little bit about the stress test itself. What was the Fed looking for, and what were the results of those tests?

Peters: Well, there were two components to it. First is that the Fed wanted to see how the 19 largest banks in the country would fare in a recession or a financial crisis even worse than downturn that we went through in 2008 and 2009. Basically, the Fed was looking at whether the banks are generating enough revenue and have enough residual capital leftover that they could withstand literally hundreds of billions of dollars of additional losses on their loan and investment portfolios and still be able to maintain adequate capital ratios.

The second piece of this took the same set of assumptions about profitability, capital, and loan losses, but also included what managements of the different banks submitted in terms of their plans for returning capital to shareholders through dividends and share repurchase. So, what we saw was that most of the banks fared reasonably well on the first test, but there were some in which the Fed came back and said, "We're really not comfortable with you increasing your returns to shareholders at this time because your capital ratios after a period of intense stress would just be too low."

Glaser: Let's look some individual names then. Who failed these tests? Who did the Fed say this capital plan just isn't sufficient?

Peters: Well, of the 19, there were four institutions that didn't pass the test. One of them Ally Financial, the former GMAC, is not a publicly traded company, so there was not a lot of impact there. Citigroup was another. It fell just short of the minimum capital ratio requirements when its plans for repurchasing shares and increasing the dividend were included. So, essentially the bank is going back to the well. They are going to have to rework their plans and submit a new one.

SunTrust Banks was another bank that failed. That was a little bit surprising. SunTrust had wanted to raises its dividend and look at share repurchases. Management felt like the Fed's assumptions regarding future loan losses were too aggressive for their circumstances. The bank would expect to fare better, but the regulators' word is a law there. And the final one was MetLife, which most of us think of as an insurance company because it is. But it became a bank holding company back during the crash, so it falls under this supervisory assessment regime. MetLife was also looking to raise their dividend and repurchase shares. The firm felt like the test was unfair; you kind of would expect management to say that. But in any event, MetLife won't be looking to increase cash returns to shareholders right now.

Glaser: So, let's take a look at the good news for the companies that did pass. What kind of dividend increases did you see, and were you surprised at the size of them?

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