Dividends seem to be the first major casualty of squeezing credit. Credit markets generally go down following any turmoil in prime mortgages. When loan defaults rise due to the housing meltdown, there is a greater need to conserve cash.
There has been a downward pressure on credit markets since the second half of 2007 because of the mortgage defaults by home buyers with low credit scores. Sub prime mortgages have been especially hit hard with estimated defaults to the extent of about $100 billion. This is a huge figure. There is continuing uncertainty.
What are the implications of the above? Rising defaults of loans implies losses for financial institutions, strain on earnings, less availability of cash and reduced investment by investors in bonds and debt. Because of this they not only need to conserve cash but also the need to raise further capital.
Since there does not seem to be much scope to raise further capital from the capital markets from the sale of bonds and debt backed loans, banks and financial companies have started slashing dividends.
Citigroup and Washington Mutual are the first two major financial firms to reduce dividends. Consequent to a cut of dividend by 15 cents by the latter, the share price of this company has gone down by about 25 per cent so far. Citigroup is expected to reduce it by a bigger amount. There may be more companies.
As the woes of defaulting loans continue, more and more banks are likely to cut dividends. If the credit markets continue to fall and the US economy weakens, other areas of the economy like the consumer sector may also start feeling the pains or credit squeeze. That way they may also start cutting dividend rates.
According to Standard and Poor's, more companies slashed dividends during 2007 as compared to 2006 than the ones that increased.
The importance of dividends can hardy be underestimated. These are important not only for the maintenance of share prices and as a major source of income for many investors, but for the overall health of the economy as well. This provides one of the important barometers of the state of business.
If financial institutions are facing cash shortage, they will not be able to meet the credit needs of the market. That way, the overall economy may further go down putting pressure on earnings, dividends and share prices.
Falling dividends have an immediate impact on share prices as has been shown by those of Washington Mutual. If such cases are isolated and transitory, that could provide an excellent opportunity to investors to buy shares at very low prices which may be temporary. However, the present scenario does not seem to be confined or short term. Falling dividends may seem to be a recurrent phenomena and the symptom of a wider malaise.
Investors need to brace themselves not only for a considerable reduction in dividend income, share prices but also further investment. If the US economy weakens further, it might be appropriate to conserve cash or to think globally and investment in emerging markets.
The author has background in business, economics and finance. He is presently researching in finding ways to make money and working on the following website and blogs: