How Financial Reform Impacts Bank Investors

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. How will the financial reform legislation, working its way through Congress impact bank dividends? I'm here with Josh Peters, Editor of Morningstar DividendInvestor, to see how investors in banks will fare. Josh, thanks for joining me.

Josh Peters: Happy to be here.

Glaser: How do you think the financial reform legislation, in front of the Senate right now, is going to impact those stocks?

Peters: Well, I'll tell you, it depends very much on the firm. I think the financial services industry in this country, and globally, has certainly earned greater regulatory oversight. It has maybe in fact earned some public dressing down. I mean, what could be more embarrassing than being dressed down on TV by congressmen? You know, that really has to be humiliating, but look at what some of their actions had brought us to.

I think the way the industry is heading is actually in a relatively positive direction. For investors who bought a stock like a Wells Fargo for a big dividend saw that dividend almost entirely taken away, now just running at five cents a share per quarter. The industry is going to kind of migrate in the direction of the way a Wells Fargo has been running its business. It's going to be about taking deposits. It's going to be about making loans. It's going to be about getting repaid in full and on time, from the loans that they make, and being responsible to their shareholders, their employees, their customers, in a more comprehensive and traditional way in banking.

Now, what I like about Wells Fargo is it shows that you can have a very profitable bank without having to do what Goldman Sachs does, or what JP Morgan Chase does, all the derivatives activities. Proprietary trading, hedge funds, private equity, all the rest of that stuff, you don't need it in order to have a profitable bank that generates a lot of excess capital. And if Wells Fargo continues creating excess capital at the rate it has been lately, I think a dividend increase, even as early as late here in 2010, is a very strong possibility.

Glaser: But some of these traditional banks are still going to be impacted by this legislation. There's a lot of talk of regulating debit card fees, and overdraft fees, some of which have already come into effect, and some of which could, if this gets passed. Do you think these businesses will be able to overcome those obstacles?

Peters: I don't think that there's any financial services company that is going to be excluded, or completely untouched, from this legislation. The rules are tightening from all directions, and for everyone. But the rules are going to change much more dramatically from the hybrid universal banks, or investment banking operations like a Goldman Sachs, that really had their business models built off of deregulation. It's going to be much, much more difficult to adapt to a more regulated environment.

For somebody like a Wells Fargo, some of the bigger changes in this bill, about perhaps about having some real state regulation of their operation, state by state regulation of their operation, it's almost more of an IT problem and an employee compliance problem, as opposed to something that is going to radically change their business model.

But the way I look at it is that the bottom line is actually fairly simple. I mean, you can restrict the activities of traditional bankers, but to the extent that you restrict their activities, you are also perhaps also restricting access to credit. And that will lead to higher prices for credit. Customers will pay more on loans. They'll earn less on deposits.

Banks are going to have to make up for these additional operating costs somewhere. And I think those costs will be passed along to customers. The cost of capital in the banking sector, if anything, has gone up. And I would expect the better banks, that face less competition - now after all of the banks that were washed out of the system during the crisis - they're going to be able to capitalize on that.

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Glaser: Will the removal of regulatory uncertainty help boost dividend yields?

Peters: Well, the stuff that's being addressed in the Senate legislation right now would help a little bit, but the biggest hurdle out there is really the Federal Reserve. Which has the power to essentially stop banks from raising or paying their dividends, unless they're comfortable with the bank's individual capital positions and overall soundness. The Fed's been pretty reluctant to let anybody raise their dividend. They would rather that banks continue to accumulate capital against the event of say a double-dip recession or a very prolonged period of very high credit losses.

But I think we're going to see clarity on that front, see new capital standards published, and established, and enforced, for the US banking industry at some point this year. After that point, once banks know where they stand, know how much capital that they have to have, and perhaps how much more they'd like to have on top of that, as an extra safety cushion, then the rest really needs to go back to shareholders. And I think dividends are going to be the primary way that those funds go back to shareholders, going forward.

Glaser: So investors, looking for bank dividends again, maybe don't need to be so concerned about the current financial reform bill. But does it make sense for them to buy bank stocks now, or to hold the bank stocks that they already own?

Peters: I still think it's a little bit different to go out and buy them. A lot of it really comes down to price, and I tend to be kind of a cheapskate on that count. Having already been through a lot of disappointments in this industry, I think one way that you can protect yourself is by holding out for lower prices, bigger discounts to what we think these bank stocks are worth.

But I think we're definitely in a range, that even if they're not quite buyable at these prices, that it's worth investors who continue to own them - even though they'd like to get a bigger dividend yield right now - to hang on a little bit longer. I think within about a two-year time frame, maybe even by the end of 2011, maybe 18/19-month time frame, we're going to start to see significantly higher dividends from the better players in the industry.

And that is Wells Fargo, US Bancorp, BB&T. I think, that kind of a time frame, you're going to see dividends come off of this very low level, to start providing more traditional two, three, four percent type of yields again. If it's Bank of America, all right, I think you're waiting a lot, lot longer to really get a meaningful dividend coming bank. If it's Citigroup, maybe your grandchildren will get it, I don't know.

But for the better players, I think that the picture continues to improve. And the financial reform package, that's working its way through Congress right now, is not materially going to set that back.

Glaser: Josh, thanks for joining me today.

Peters: Happy to be here.

Glaser: For Morningstar.com, I'm Jeremy Glaser.