Banks have always paid dividends, but for most of the 1990s they posted yields below 3 percent. Then, in the first decade of the new century, banks became great stocks for dividend investors by offering a great package of total return with fast earnings growth and rising payout ratios.
Then in the fiscal crisis of 2008, the entire banking industry blew up. Many banks went out of business and of those that survived, many either cut their dividends or eliminated them entirely. J.P. Morgan Chase, the strongest of the bunch, cut its dividend by 87 percent in early 2009.
In the aftermath of the bank bailouts, with dividends and balance sheets decimated, the banking sector as a whole isn’t promising. However, the banks that do come back will be much stronger. Some experts think the banks that survive will eventually try to bring their dividends up to former levels quickly.
Not every bank filled its loan portfolio with loans to subprime lenders and credit default swaps. Many banks maintained a conservative business strategy. They not only survived but also came out much stronger and were able to grab market share by buying competitors. These survivors are the banks you want to put your money in. They shouldn’t be too hard to find — they’re the ones still paying a decent dividend.
The pros and cons of investing in banks
If you’re waffling about whether to invest in banks, consider the pros and cons.
In terms of stability and reliability, banks actually have a lot going for them:
Plentiful supply of cheap money: Banks have a constant source of cheap funds: depositors. Most other lending institutions need to form partnerships or sell equity or debt to investors to raise the money they lend. These companies pay a premium for that money by giving away part of the company or paying interest. Not banks. Customers just hand them cash, practically for free, relying on the bank to keep their money safe and liquid.
Customer stability: When customers choose a bank, they tend to stay put because the time, money, and hassle of changing banks typically outweigh the benefits.
Stiff regulation: Banks are a heavily regulated industry, and after the banking fiascos of 2008 and 2009, regulators are becoming even stricter in monitoring banks and enforcing regulations, which benefits investors.
Economies of scale: Size matters. A huge company can force suppliers to give it better, cheaper goods than competitors; it then spreads the fixed costs over a greater number of stores. By lowering its cost of doing business so much, it can still make huge profit margins while charging less than its competition.
Don’t assume that investing in banks is 100 percent risk-free. Investors who owned stock in Washington Mutual learned this lesson the hard way in September 2008, when the FDIC seized Washington Mutual — a bank that held a loan portfolio with $307 billion in assets. WaMu was the largest bank failure in U.S. history. Depositors got their money back. Shareholders lost everything.
Another risk of investing in banks is, well, risk. Banks act as financial intermediaries between the people who need the money and the people who have it. As banks manage the money that flows through them, they assume two types of risk, interest rate risk and credit risk:
Interest rate risk: Banks may pinch pennies, but sometimes they can get pinched, too. More precisely, their net interest spread (the difference between the rate they charge on their assets and the rate they pay to their liabilities) can feel the pinch when the interest they collect on loans dips, the interest they pay on deposits rises, or both. To offset a tightening of the spread, the bank may institute more fees and charges to make up the missing revenue.
Credit risk: Credit risk is the likelihood that a bank will lose part or all of the principal, as well as the interest, in the event a borrower defaults on the loan.
Watch out for super-low interest rates. In late 2009, interest rates in the U.S. were at historic lows. The federal funds rate (the rate banks charge each other for overnight loans), sat between 0 and 0.25 percent. Interest rates had nowhere to go but up, and when interest rates rise, banks and other dividend investments, including utilities, may feel the pinch.