4 Reasons Bank of America's CEO Prefers Buybacks Over Dividends

Brian Moynihan will face the public-relations equivalent of a tar and feathering if Bank of America doesn't get permission from the Federal Reserve to increase its dividend next week. But that doesn't mean he wouldn't rather do something else with the money.

Over the last few years, Moynihan has made no secret of his preference for share buybacks over dividends as a way to return capital to shareholders. And, to a certain extent, it's easy to understand why.

In the first case, Bank of America's stock continues to trade below book value. Although I'm not a fan of share buybacks in general, there's simply no denying the fact that repurchasing stock at a 20% discount to book is accretive to shareholders.

Second, Moynihan has been burned before on the subject of dividends. In 2011, his executive team preannounced their decision to raise dividends only to learn weeks later that the central bank wouldn't allow the bank to do so. The misstep made it seem as if Moynihan wasn't on top of things, and caused analysts and commentators to question his ability to lead.

Third, the Fed's capital review process -- the Comprehensive Capital Analysis and Review, or CCAR -- inherently favors buybacks over dividends. The central bank has largely ruled out payout ratios above 30% for all but the best banks. And, more importantly, the associated stress tests seek to determine if a bank can meet its regulatory capital ratios in periods of extreme stress, inclusive of any planned capital actions.

The latter (italicized) phrase may seem innocuous. However, when it comes to stress tests and bank capital, it's anything but. This is because buyback programs are typically finite, while dividends are presumed to continue on indefinitely under the CCAR framework. Here's how the Fed explained it in the guidance for this year's test (emphasis added):

the Federal Reserve will in part be assessing whether a [bank holding company] would be capable of continuing to meet minimum capital requirements and a tier 1 common capital ratio of at least 5 percent throughout the planning horizon even if adverse or severely adverse stress conditions emerged and the [bank holding company] did not reduce planned capital distributions.

The final reason Moynihan prefers buybacks over dividends is because he feels an obligation to make long-term investors whole. Between the beginning of 2008 and the middle of 2010, Bank of America's outstanding share count more than doubled. And it did so after the stock price had plunged, sucking an egregious amount of value out of existing shareholders' stakes.

"We need to get back most of the shares we issued in the crisis, that caused all the dilution," Moynihan told Fortune's Shawn Tully in 2011.

With these four issues in mind, it's easy to see why an executive in Moynihan's shoes would prefer share buybacks to dividends -- and particularly when you consider the specific set of facts confronting the nation's second largest bank by assets. At the same time, however, Moynihan also has a duty to appease the bank's income-seeking investors.

Will he find the right balance this year? While I was wrong on this count last year, my guess is that he will by announcing both a modest dividend increase and a renewed buyback program.

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The article 4 Reasons Bank of America's CEO Prefers Buybacks Over Dividends originally appeared on Fool.com.

John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. 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 Motley Fool has a disclosure policy.

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