Bracing themselves for at least several more months of economic misery, some community banks across the Puget Sound region are taking the unprecedented step of suspending their quarterly shareholder dividends or slashing them to several cents on the dollar.

Everett-based Frontier Bank and Bellingham-based Horizon Bank have decided they won't pay dividends to shareholders in the first quarter, while Seattle-based Washington Federal Savings has cut its dividend by 76 percent to 5 cents per share—the first time it has slashed its dividend in the bank's decades-long history.

Banks are choosing to hold on to the cash that they would typically pay out to shareholders to buffer against future losses on bad construction loans, says Sara Hasan, a bank analyst with Seattle-based McAdams Wright Ragen brokerage.

Puget Sound region banks have seen their problem loans increase dramatically over the past year, and many banking experts predict the pain will continue for at least the first two quarters of 2009.

The result is a loss to shareholders of community banks who likely won't see their dividends restored or increased for the near future.

While banks nationwide also are slashing their dividends, Puget Sound-area banks haven't faced dividend cuts for a "very, very long time," says Hasan.

The new strategy of conserving cash is a warning signal that the economic woes of 2008 won't immediately subside with the start of a new year—and their effects will likely linger across the region for months to come.

"I think economic conditions in the Northwest have worsened in the last three months," says Hasan. "You're seeing banks look at their capital base and say, 'Hey, what if this lasts for a prolonged period of time? We need to make sure we're prepared.'"

Banks that have chosen to suspend or cut their dividends have been punished by shareholders.

After Washington Federal announced recently that it would decrease its quarterly dividend from 21 cents to 5 cents, its stock dropped to a yearly low of $11.55, down from a high of $27.44, a decline that chief executive Roy Whitehead says he wasn't expecting.

The bank quickly released a further explanation of its decision to reduce its dividend and offered guidance on its upcoming first-quarter report in an attempt to reassure shareholders.

"We were surprised at the extent to which it was reflected in the prices," Whitehead says.

Frontier Financial Corp., the holding company for Frontier Bank, was dealt a similar blow.

Its stock dropped to about $3.40 recently, down from a high of $4.12 earlier in December, after its announcement that it would suspend payments. Horizon Bank, in Bellingham, which declined comment, saw similar decreases.

But banks say saving millions of dollars that would have been paid out to shareholders is better for the health of the bank—and, in turn, their investors—in the long run.

Frontier Bank has never suspended a dividend payment, but chose to cut its shareholder payout for the first quarter to bulk up its capital reserves, says Pat Fahey, chief executive of Frontier Financial Corp.

The bank had already slashed its dividend earlier this year to 6 cents from 18 cents.

Like many banks across the Puget Sound region, Frontier lent heavily to home builders and land developers and is now facing a slew of problem loans as a result of the housing market's downturn.

By holding on to the money normally paid out in dividends, Fahey says the bank is protecting itself from "future deterioration that may occur."

"It was a difficult decision, believe me, but there needs to be some tough decisions made in tough times," he says.

Washington Federal similarly is trying to bulk up its capital cushion in the face of rising bad loans by cutting its dividend for the first time even though it recently received a $200 million cash infusion through the federal government's new bailout plan.

"From our point of view, the (federal) money is strictly a loan," says Whitehead. "We're required to pay that money back."

Whitehead says it was necessary for the bank to add to its capital base because of ongoing economic problems across the country that he expects will continue to worsen in the first part of 2009.

In its first-quarter guidance released on the heels of its dividend cut, Washington Federal says it expects problem assets of $300 million, or 2.43 percent of total assets, in the first quarter.

"We see real estate values continuing to decline," says Whitehead. "We quite frankly just don't see the bottom of it yet. Our experience has been that companies wait too long to take hard action."

Shareholders might not see their dividends restored at Puget Sound region banks anytime soon.

Banks that have received money through the federal government's cash infusion program, such as Washington Federal, are restricted in how high they can increase dividends and can't exceed the previous quarter's dividend.

That means Washington Federal shareholders won't see their dividends increase to more than 21 cents a share if the bank does opt to raise them again.

Even banks that haven't received federal money aren't expected to restore their quarterly rewards anytime soon.

"It's tough to say," says Hasan. "It's going to come down to each individual bank and how they're feeling. I would think that most companies will be hesitant to raise them."