In the past, bank stocks were an excellent source of dividends for income-oriented investors.

The traditional “3-6-3″ model of banking – borrow at 3%, lend at 6%, and be on the golf course by 3 p.m. – led to nice, if somewhat unexciting, lives for bankers. It also offered a stream of reliable dividends for shareholders.

But today, bank deposits are a rotten investment, as they pay almost nothing (though they at least have a Federal deposit insurance guarantee). Meanwhile, bank stocks don’t pay much more and are subject to the storms of the next financial downturn.

It sure seems as though bank stocks are a total disaster right now…

How Did We Get Here?

When monetary policy was relaxed in 1995, the banking model changed significantly.

The largest banks charged into all sorts of exotic derivatives, and they were incapable of managing the associated risks. Smaller banks, pumped up by easy money, rushed into subprime mortgage, real estate, and leveraged buyout lending – and they never even attempted to manage the risks.

The result was a massive bank bailout in 2008, after which all the banks slashed their dividends close to zero to rebuild capital.

On the other hand, seven years of zero interest rates pumped up bank profits and encouraged them to lend to more real estate and leveraged buyouts, as well as energy and (to a lesser extent) technology startups.After 2008, nothing much changed except that the Feds kept inventing newer and more arcane excuses for levying billion-dollar fines on the largest banks, which played merry hell with their profitability.

Dividends, though, didn’t rise to their previous levels, as even 2% yields kept share prices safely above their net asset value. Thus, the largest banks aren’t very interesting investments for income investors these days.

JPMorgan Chase (JPM), for example, yields just 2.9%. Even the most solid of the big banks, Wells Fargo (WFC) – which does less investment banking than its peers – has only a 2.6% yield. That’s not chopped liver in this era of deposit rates below 1%, but it also doesn’t pay for the risk of another market meltdown, bank bailout, and accompanied shareholder dilution.

Searching for Decent Bargains

Luckily, a number of small- and medium-sized banks offer better dividends – though there are additional risks attached.

Some medium-sized banks have gotten themselves into exotic businesses that they don’t really understand. Valley National Bancorp (VLY), for example, is heavily into aircraft leasing. Others are excessively concentrated in the oil patch, which is likely to be a source of bad debts at a time when oil prices have halved.

Finally, others are heavily into overpriced urban real estate in New York or San Francisco, or they’re in commercial real estate in places such as upstate New York, where the local economy has barely a twitch of life.

Still, the twin killers of the last downturn – home mortgages and consumer lending – are likely to be less of a problem next time, so there are some decent bargains around. Let’s take a look at a few:

• New York Community Bancorp Inc. (NYCB) boasts a juicy yield of 5.9%, although the dividend is only just covered by earnings. It specializes in lending to multi-unit homes in communities like New York City, where rent control is prevalent. That’s a dangerous specialization, but not obviously suicidal.

• Citizens Holding Company (CIZN), on the other hand, is a small bank specializing in consumer banking and home lending around Philadelphia, Mississippi. It boasts a dividend yield of 5.1%, which is well covered by earnings. Plus, southern states don’t have problems with overblown real estate prices, big fracking activity, or decayed Rust Belt economies. CIZN’s problem is that it’s small – just an $88-million market capitalization.

• The First Bancorp, Inc. (FNLC) is a similarly consumer-oriented bank in coastal and eastern Maine, boasting a 4.8% dividend yield. There’s some danger here from its operations lending to pleasure boats and RVs, but the bank looks generally solid. And with a $178-million market cap, it’s larger than CIZN.

• Finally, Northwest Bancshares, Inc. (NWBI) is a larger bank with $1.1-billion market capitalization and a 4.7% yield. NWBI operates 165 community banking offices in Pennsylvania, upstate New York, Ohio, and Maryland – in addition to 50 consumer finance offices in Pennsylvania. Being consumer-oriented, it has little direct exposure to small fracking oil, which is prevalent in the region – though you can worry that its customers may be dependent on that troubled industry. Still, on balance it appears one of the safer 4.7% yields around.

Bottom line: Income investors have typically shunned the banking sector since the disasters of 2008. However, the shares of small- and medium-sized banks may be attractive homes for part of their money, so long as the banks aren’t obviously doing something stupid.

Good investing,

Martin Hutchinson