Options market implies that JPMorgan and other megabanks may slash dividends after Fed stress test

Published Wed, Jun 17 20206:52 AM EDTUpdated Wed, Jun 17 20208:29 AM EDT

Options traders have placed bets implying that they expect the big banks to repeat what they did in the last crisis: slash dividends. Take JPMorgan Chase , for instance. Options contracts tied to the biggest and most stable of the U.S. megabanks imply a 33% dividend cut by January, according to a trader who runs the options flow desk for a major brokerage. The New York-based bank currently pays a 90 cent quarterly dividend, or a total of $2.70 in the three quarters through January. "The options markets is saying, `We will only pay $1.70 for that $2.70 in dividends;' it's telling me they think JP will cut its dividend by a third," said the trader, who declined to be identified because he isn't authorized to speak to the media. Banks are facing skepticism ahead of the Federal Reserve's stress test, an annual ritual where companies have to demonstrate that they can survive a severe economic downturn while continuing to make loans and pay dividends. Results of this year's test will be released June 25. Since the test is happening during a severe downturn, it will include an assessment of how banks are reacting to the real-life impacts of the coronavirus pandemic. That could trip up banks, according to KBW analysts led by Brian Kleinhanzl. If the Fed were to boost its assumption for loan loss reserves while requiring higher capital levels in its most extreme scenario, it's possible that JPMorgan, Citigroup and Goldman Sachs would have to cut dividends to conserve capital, he wrote in a May 26 report. After bank shares tanked in March, investors began placing bets that the industry's dividends would have to be cut, market participants said. That's what happened in the U.K. after that country's banking regulator pressured lenders including Barclays , HSBC and Royal Bank of Scotland to scrap their payouts. Accurate bets Options, which are tied to the future price of a stock and incorporate factors including upcoming dividend payments, can be used to estimate the market's expectations for a company's quarterly payout. Ahead of the 2008 financial crisis, options traders accurately bet that Citigroup would be forced to cut its dividend, which it eventually did , slashing it to a penny in 2009. Most analysts who cover banks believe the market is being overly pessimistic, citing robust levels of capital heading into 2020 and improved oversight since the financial crisis. Their case is supported by the fact that in March, six of the biggest U.S. banks proactively declared they were halting buybacks, which use up roughly three times more capital than dividends. "We still expect the largest banks that we cover to pass [the stress test] and to do so with capital at an estimated $80 billion" over the minimum required, Wells Fargo bank analyst Mike Mayo said in a June 10 research note. "Our conclusion is that the Fed is unlikely to induce across-the-board dividend cuts, including [at] our favorite Citigroup." If JPMorgan were to cut its dividend, it would be for the first time since the Great Recession. Banks were allowed by the Fed to increase dividends starting in 2011, and JPMorgan has increased its payout every year since then. Last year, the bank generated a record $36.4 billion profit. 'A drop in the bucket' "Remember, this time around, the real capital being used is to buy back stock and all the banks stopped that," JPMorgan CEO Jamie Dimon said last month during a banking conference. "People are a little misguided when they talk about dividends. It's a drop in the bucket." Nonetheless, since the pandemic took hold, assumptions for dividends have cratered. The options market prices a roughly 30% average decline in dividends for the seven biggest banks, Goldman analysts said in a May 29 research note. Wells Fargo , still struggling to emerge from its fake accounts scandal, faces the steepest cut at about 60% compared with its current payout, while Morgan Stanley fares best among big lenders with a 15% drop. The options market analysis provides a "rough idea" of dividend expectations rather than a precise forecast, wrote the Goldman analysts led by Richard Ramsden. That assessment is bolstered by JPMorgan analyst Vivek Juneja, who said in a June 2 note that Wells Fargo faces the highest risk of being forced to cut its dividend. That's because its earnings have stagnated in recent years, which could hurt its standing in the Fed stress test, Juneja wrote. Still, some of the options activity feeding dividend doubts is probably more technically driven, according to Jon Najarian , a veteran options trader and CNBC contributor. Some investors are buying puts to lock in gains made after bank shares rebounded from their March lows, he said in a telephone interview. And if banks mostly end up keeping their dividends intact, investors now have an opportunity to make money by buying shares and selling calls or forwards. "If you are telling me that the Citigroup or JPMorgan dividend isn't going down, I'd go out and accumulate positions that would make a lot of money if they stayed the same," said the anonymous head options trader.

Spencer Platt | Getty Images

Options traders have placed bets implying that they expect the big banks to repeat what they did in the last crisis: slash dividends.

Take JPMorgan Chase, for instance. Options contracts tied to the biggest and most stable of the U.S. megabanks imply a 33% dividend cut by January, according to a trader who runs the options flow desk for a major brokerage. The New York-based bank currently pays a 90 cent quarterly dividend, or a total of $2.70 in the three quarters through January.