Tempted by Financials' Fat Dividends

Share prices of big names like Citi and WaMu have taken such a hit that they now offer eye-popping payouts. Buyer beware

Thanks to a $7.5 billion deal with an Abu Dhabi investment fund this week, Citigroup (C) shored up its capital with one big goal in mind: preserving its dividend payment, which at a 7% yield is one of the only bright spots for a bank facing massive credit losses.

Citi's big dividend yield, which has soared as its stock dropped 24% in the last month, is a common feature among large financial institutions these days. A dividend yield of 6%, 7%, or even 13% can be an incredible opportunity for investors seeking big returns. But the higher the yield, the more likely it is a mirage that will evaporate as financial losses mount in future quarters.

A rally for financial stocks on Nov. 28—probably due to higher hopes for a Federal Reserve interest rate cut—lowered yields somewhat from peak levels. But dividend yields are still sky-high for many names in the group. Washington Mutual (WM), for example, offers a 13% payout, the highest in the Standard & Poor's 500-stock index.

Too Good to Be True?

According to Nov. 27 data from Capital IQ, 15 of the 20-highest dividend yields in the S&P 500 came from financial stocks. They include financial giants WaMu, Citigroup, Countrywide Financial (CFC), Freddie Mac (FRE), Fannie Mae (FNM), Wachovia (WB), and Bank of America (BAC). All these face big exposure to the troubled mortgage market.

High dividends can be attractive to investors hoping to wait out a market downturn: Even if the stock market stays flat, these companies will continue paying you a premium for staying in the stock. However, "if the dividend is too high, it doesn't pass the too-good-to-be-true test," says Kirk Mentzer, director of research at the Huntington Dividend Capture Fund.

Indeed, Freddie Mac, previously sporting a yield of about 8%, announced Nov. 28 that it will cut its fourth quarter dividend in half.

"Blind Pools of Risk"

At least some investors and analysts think the Citigroup dividend is now safe, at least for the short term. However, even those optimists may acknowledge that the high price of the deal—offering the Abu Dhabi investors a yield of 11%—was "another indication of the weak management of Citi's attractive franchise," JPMorgan (JPM) analyst Vivek Juneja wrote.

Analysts who have been even tougher on Citi—namely CIBC World Markets' (CM) Meredith Whitney and Deutsche Bank's (DB) Michael Mayo—warn the financial giant may still have to slash its dividend to stay afloat. "We are only in the early stages of [Citigroup's] capital pressures," Whitney wrote. "Losses…will mount at an alarming rate over the next several quarters."

Matthew Kaufler, portfolio manager of the Touchstone Value Opportunities Fund, warns high dividend yields are "there for a reason." Either the company is in a sector out of favor with the market, or investors are betting the dividend won't be sustainable. Kaufler's fund owns Citi, and he says its dividend is safer than the yield of Countrywide or WaMu. But the problem with buying shares of any of these players now, he adds, is "you're investing in blind pools of risk."

Plesser's Picks

What's been remarkable is that even sky-high dividend yields haven't persuaded investors to take a chance on these troubled companies. You would think a high dividend provides a "floor for the stock," says Eric Boyce, portfolio manager at Hester Capital Management. "It's such a crisis of confidence now that people just don't want to own these things."

Investors judging the riskiness of a dividend must do so on a case-by-case basis.

S&P equity analyst Stuart Plesser doubts WaMu's huge dividend yield is safe. Another bank, First Horizon National (FHN), with a yield above 8%, is "high risk," Plesser says. Fannie Mae appears to be in better shape than its fellow government-sponsored enterprise, Freddie Mac, but could also cut its dividend if it continues to rack up big losses, he says.

However, Plesser likes the attractive yield, 5.9%, on a stock like New York Community Bancorp (NYB), which he says has "pristine" credit. Regions Financial (RF), with a yield of 6.2%, also looks "pretty safe."

Elusive Estimates

The problem is that even analysts and fund managers can strongly disagree on the likelihood of a dividend cut. For example, while much of the market flees from WaMu, Morningstar (MORN) analyst Erin Swanson says she has reviewed WaMu's debt exposure and believes its dividend payment is sustainable.

It's tough to quantify the piles of risky mortgage debt on these institution's balance sheets. It's even harder to predict future losses as home prices continue to fall and homeowners see mortgages reset to higher interest rates. Many experts advise looking closely at a firm's real cash flows—rather than accounting write-offs—when predicting dividend payouts.

The best case scenario for the large financials is that, while the housing and mortgage markets remain tough for a while, "this crisis of confidence" ends, Boyce says. If buyers reenter the debt markets, big banks may see their losses stabilize. For the worst-case scenario, watch housing prices, S&P's Plesser says. A steep drop in home values will translate into deep losses on mortgage debt.

Mitigating the Impact

The irony is, in economic downturns, financial stocks often do quite well, partly because of their high dividends. Firms like WisdomTree Investments (WSDT) tout funds of stocks weighted by their dividends. Dividend-yielding stocks offer "higher returns and lower volatility," WisdomTree Director of Research Luciano Siracusano says, acknowledging that this year, with the poor performance of financial stocks, has defied historic trends.

Rather than betting on individual stocks with high yields, Siracusano recommends buying portfolios of stocks with high yields to mitigate the impact if any one stock needs to cancel or cut its payout.

Huntington Dividend's Mentzer, whose fund also focuses on dividend stocks, says he's avoiding financial stocks and hunting for other sectors with good dividends. He likes large technology and industrial companies with an international presence, as well as pharmaceutical stocks with good payouts.

Still, with two-year Treasury yields barely above 3%, a yield of 13% looks awfully tempting. But if you want to drink from the financial oasis, you need to be aware it may turn to sand in your mouth.

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