Tomorrow's Dividend Kings Pass the Test

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With last week's third anniversary of the financial crisis, investors had a chance to think back on just how bad things got for their investments. In particular, many investors who relied on income-producing stocks got hit twice: Not only did they suffer huge share-price losses, but some of those stocks also cut their dividend payments to the bone.

In order to declare final victory over the market meltdown, you have to take a hard look at the epicenter of the crisis: the financial sector. With so many banks almost eliminating their dividend payouts after taking TARP bailout money back in 2008, nothing would slam the door on the bear market harder than to have the banks reestablish their former status as dividend kings.

The Federal Reserve's stress tests have given banks exactly that opportunity. Yesterday's announcement of the Fed's latest stress-test results were a mixed bag, as you'll see below. But first, let's take a brief look at the history of the stress tests since the financial crisis.

Looking back at last year
Back in 2009, the first round of stress tests reveals a big need for banks to raise capital. Yet the second round of stress tests last year gave banks their first chance to redeem themselves. Following that episode, the banking sector found itself divided into haves and have-nots.

Right after last year's stress-test results, JPMorgan Chase (NYS: JPM) raised its dividend by 400%, pushing its yield at the time back over the 2% mark. Wells Fargo's (NYS: WFC) less-extreme 140% boost produced a yield of about 1.7%, while US Bancorp's (NYS: USB) 150% jump got its yield close to 2%.

On the other hand, Bank of America (NYS: BAC) wasn't given permission to increase its dividend. Citigroup (NYS: C) came out with a $0.01 dividend, but only after a reverse split that made that payout worth only 0.1% in yield.

The latest results
This time around as well, the stress test results were a mixed bag. JPMorgan Chase and US Bancorp passed the tests and immediately announced dividend increases and stock buyback programs. JPMorgan's yield would rise to nearly 3% under its proposed hike, while US Bancorp plans to boost its payout by a whopping 50%.

Bank of America also managed to pass the test, but unlike JPMorgan and US Bancorp, B of A doesn't plan to raise its dividend. Meanwhile, Citigroup failed the tests, along with SunTrust, Ally Financial, and MetLife.

A long way to go
Even after these largely favorable results, most financial institutions still have a long way to go to reestablish themselves as dividend kings. In late 2006, Bank of America and Citigroup both paid yields of around 4%. JPMorgan's yield is getting close to its typical levels in 2006 and 2007, but US Bancorp would have to get back to between 4% and 5% to match its 2006 yield.

Of course, banks may never return to their high-income heyday during the middle of the last decade. A unique combination of a soaring housing market and relatively low interest rates boosted mortgage activity, and the free flow of capital between banks and government-sponsored enterprises Fannie Mae and Freddie Mac made it possible for banks to collect huge amounts of transaction-based income from mortgage-financing operations. With Fannie and Freddie under conservatorship, it's unlikely that they'll ever return to their previous role as ultimate clearinghouse for the mortgage market.

Moreover, future rounds of stress tests will prevent banks from using the leverage that resulted in such huge losses during the crisis. That's a positive thing for preventing future problems, but it also limits the amount of upside profit potential for banks.

Showing you the money
Still, while B of A and Citi may never restore their pre-2008 dividends, JPMorgan, US Bancorp, and Wells Fargo look like they're still on track to become dividend kings again in the future. Even if they never match their historically high yield levels, the healthier banks are taking big steps toward returning money to their investors, and that's a good sign for bank-stock investors to feel optimistic about their prospects.

Dividends are an important part of successful investing. To find some promising picks, let me suggest reading the Motley Fool special report "Secure Your Future With 9 Rock-Solid Dividend Stocks." I invite you to grab a free copy to discover everything you need to know about these nine generous dividend payers.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time this article was published Fool contributor Dan Caplinger never met a stress test he didn't like. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase, Wells Fargo, Citigroup, and Bank of America, as well as creating a covered strangle position in Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy passes all the right tests.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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