In the fall of 2007, Bill Miller, then considered one of the finest fund managers of the modern age, sat down at a lunch table at a private club in downtown Toronto and scoffed at the signals of doom.
"The underlying global economy looks okay," he said, before launching into a soliloquy on why it was the best time to buy bank stocks in years, if not decades. The mortgage mess? Worry not. Credit crunch? Bah. "All of the stuff that has been headwinds to Citigroup and JPMorgan, and is currently headwinds to those guys, will turn into tailwinds in the next 12 months."
Or not. Or the "headwinds" turn into hurricanes. Or Citigroup effectively goes broke and Bear Stearns and American International Group, two other financial firms in which he had placed a big bet, both collapse. Late last year, in an interview with The Wall Street Journal, a humbled Mr. Miller admitted that he'd blown it. His time-worn rules of investing - the ones that had carried him through the crash of '87, the early '90s recession, the crisis of '98 - didn't work.
They didn't work because this time is different. The crisis is deep, global and driven by consumer debt, or an excess of it. In 1981-82, the economy was brutal, but American and Canadian consumers had more savings and less debt. Yet investors of all stripes still fall back on their old habits and their history. Take dividends: Are the ones paid by the big Canadian banks sustainable? Of course, the analysts and fund managers cry in unison, they haven't been cut during any postwar recession (with one exception). Right. And why is that relevant if this is the biggest crisis since the 1930s?
The debate over the safety of bank dividends runs hot because they're a last refuge for the income-seeking investor. Government bonds have puny yields. Income trusts are blowing up everywhere and some big ones, like Precision Drilling, are cutting their payouts to zero. Even foreign blue chips are giving it up. Dow Chemical's dividend cut this week was the first since the company's founding in 1897. General Electric may be next.
Still, the Canadian banks hang on. Bank of Montreal's 9.4 per cent yield says the market has priced in a dividend cut. Yet when the bank thought it needed more capital last year, it passed the hat for $1-billion, rather than trim the payout. Some people think CEO Bill Downe would have been risking his job if he'd cut because the bank has made an aggressive dividend policy a selling point to investors. That's how sacrosanct dividends are.
So why worry? Isn't it true that all the big banks, even BMO, are projected to earn more than they'll pay in dividends this year? Yep. Peter Rozenberg of UBS calculates that if profits drop 30 per cent, the six largest banks will be paying out three-quarters of their earnings, which still leaves them a bit of wriggle room. But even if it's worse, it doesn't necessarily mean lower dividends. Big bank earnings plunged in 1982, 1987 and 1992, but the Big Five didn't touch their payouts.
Here's the problem: All three of those were one-year blips on Bay Street, followed by a strong rebound the next year. What matters here - the thing bank investors will have to watch - is not the depth of the recession but the duration. Any Canadian bank, provided it's not insolvent, will carry its dividend in a bad year. What hasn't been tested since the Depression is what they will do if one lousy year turns into two or three. In other words: If Bank of Canada Governor Mark Carney is right and a recovery is on its way, don't lose sleep over dividends. But then, the world is littered with ex-Goldman Sachs guys who miscalculated the crisis (Exhibit A: Henry Paulson).
The other question is how profitable the banks will be in the new financial order, once the recovery does come. The days are likely gone when the Big Five will earn 20 or 22 cents for every dollar of equity. In the future, banks will have to carry more equity. And some high-return businesses, like some forms of securitization, are dead.
What will the new returns look like in a normal economy? If it's 16 cents of the dollar, those dividends are fine. If it's 10 or 11 per cent - watch out.
Bank CEOs are still wedded to their dividends. That's nice. But recessions have a way of making even bright financial minds cast aside the rules they've always followed. Just ask Bill Miller, bank investor.