PACWP - Is The Bank Crisis Over? We're About To Find Out

2023-06-26 10:30:45 ET

Summary

• Three of the thirty largest US banks collapsed earlier this year, raising concerns about the stability of the broader banking sector.
• Upcoming Federal Reserve stress tests and Q2 earnings reports will provide insight into the health of banks and the broader economy.
• While large banks are expected to weather the storm, dozens of smaller banks may fail over the next 12-18 months due to risky real estate loans and falling deposits.

In March, three of the thirty largest banks in the United States faced imminent insolvency after large investment losses prompted depositors to pull their money out en masse. Silicon Valley Bank ( OTCPK:SIVBQ ) was the first domino to fall on March 10th, followed by Signature Bank ( OTCPK:SBNY ) later that weekend. In Europe, Credit Suisse ( CS ) was taken under shortly after. First Republic ( OTCPK:FRCB ) managed to hang on for some weeks but ultimately folded in early May, marking the third major bank closure in the US for the year. Since then, things have been quiet on the banking front. But over the next few weeks, new data will show whether these banks were an isolated incident, or whether they were simply the canary in the coal mine. Bank stocks have been hammered this year.

• First up: the Federal Reserve's bank stress tests . These will be released Wednesday after the market close and will show how 23 of the largest banks in America would fare in a severe recession. Here, the Fed has discretion to block buybacks and dividends and to force banks to raise more capital if necessary. The stress tests will be closely watched by investors not only for their impact on the banks in question, but also for clues about where the broader economy may be headed.
• Second, banks will begin to report earnings after the end of Q2 this week. This is the first full quarter since the previous wave of bank implosions, so key questions will be answered about how the fallout has affected the specific banks and the industry at large. We've already gotten some earnings preannouncements– Charles Schwab ( SCHW ) for example preannounced that they are likely to see a larger revenue decline than expected. Schwab has a profitable brokerage attached to their bank, but is still seeing a revenue decline of roughly 11%. Given that their fixed expenses likely haven't changed, this implies an earnings decline of around 1/3. True to form, the stock is down about 35% YTD. For some smaller banks, earnings are do-or-die. First Republic failed shortly after a catastrophic Q1 earnings report, and there is a strong possibility that more banks will meet similar ends.

Stress Tests Will Likely Show Too-Big-To-Fail Banks Are Fine

The largest banks in America have been subjected to these stress tests since the 2008 financial crisis, a process that was formalized with the Dodd-Frank Act. Since then, capital ratios at large banks have roughly doubled. For these reasons, I'm not particularly worried about any bombshell revelations about the top ~20 US banks. To no one's surprise, banks had lobbied heavily for a deregulation effort that allowed fewer banks to be stress tested. Banks like First Republic and Silicon Valley Bank took advantage of this by growing rapidly in ways that would not have been allowed under the old rules. Lo and behold, they ended up failing because they took too much risk.

If you're here reading this because you're worried about your deposits at Wells Fargo ( WFC ), Bank of America ( BAC ), or Chase ( JPM ) then I have good news for you. Your deposits are perfectly safe. However, the picture may be a bit more complicated for shareholders. This requires you to do due diligence on a bank-by-bank basis.

What To Look For In Fed Stress Tests

• One key tool the Fed has in the stress tests is to block buybacks and dividend increases at banks. I feel that the Fed is likely to nudge banks to increase their capital ratios, and is likely to push back on buyback plans. Whether it goes beyond this remains to be seen.
• A harsher tool that the Fed could use is to force banks to raise capital by going into the financial markets and raising it. Doing so would be bad optics for banking stability so I think this is unlikely (after all, if the Fed says banks are fine why would they need them to raise more money). Of course, the other trouble with raising bank capital ratios in general is that it causes banks to pull back on lending, which in turn would be likely to weaken the economy. The WSJ recently reported that the Fed and FDIC were looking at doing exactly something along these lines, and have proposed a 20% increase in capital ratios for banks with at least $100 billion in assets. This would be implemented over the next few years. Like getting fit, deleveraging is a process, not an event.
• Balancing these factors, TBTF bank stocks are very cheap for investors with a long time horizon. I don't think regulation is necessarily bad for banks in the long run, and large banks are heavily discounted from where they were earlier in the year. On balance, I still think Morgan Stanley ( MS ), Bank of America ( BAC ), JP Morgan Chase, and Truist ( TFC ) are all solid buys. If you're worried about the Fed cracking down and decreasing banks' ROE for political reasons, you might prefer buying various preferred shares in banks, which carry low-tax yields of 5-7% and would paradoxically benefit from more regulation.

However, Dozens More Smaller Banks Are Likely To Fail

I think it would be naive to think that three of the 30 largest banks in America would fail in six weeks, and then not a single other bank fails, while the economy soars to new heights. Value investing opportunities in large banks are on the table because things are likely to get worse for banks before they get better. For dozens of smaller banks that aren't systemically important, they're just going to get liquidated.

Across America, banks have billions in loans in commercial real estate, much of it on vacant office buildings. Most office loans are farmed out to the commercial MBS market ( CMBS ), but plenty of regional banks have garbage commercial real estate loans on their books. Moreover, many historically safe multifamily loans now have a risk profile closer to hotel loans, with occupancy being driven largely not by demographics, but by a booming Airbnb ( ABNB ) industry goosed by stimulus money. In every business cycle, some banks go under. While I don't expect this to be as bad as 2008, investors need to know what they're getting into.

The experience from First Republic shows that West Coast banks had done crazy stuff in residential real estate as well. Take Pacific Western Bank ( PACW ) for example, the bank at the center of the latest bank run in May. PacWest is now likely among the weakest banks in America.

This is what they were advertising on their bridge loans, through their Civic Financial subsidiary:

• Stated income and no DTI requirement, No minimum FICO requirement, No minimum DSCR requirement on 1-year term
• No prepayment premium on 1-year term
• Full appraisals only required on case-by-case basis
• Interest-only payments

And here on their rental loans :

• Portfolio or single-asset loans
• 5/1, 7/1, 10/1 Interest-only ARMs
• 30-year amortized with fixed initial interest-only payment period
• Reasonable underwriting on cash flow requirements
• Aggressive LTVs / high leverage
• Min. FICO: 600
• Property Types: SFR, 2-4 units, condos, PUD's, townhomes

I would not be investing in any bank that is advertising its LTVs on ARMs as "aggressive," and that likely has a lot to with why PacWest has seen depositors flee, and why the company's credit rating is destroyed . PacWest apparently still has these loans on its books , despite selling Civic Financial to Roc360 last month. Depositors yanked at least $1.5 billion from PacWest in early May, for another 9% of deposits or so. There have been no deposit updates since.

Looking for a hedge against banking turmoil? Check out PacWest September $5 puts. They're currently trading for about $0.70, meaning they'll pay roughly 7-1 if the bank fails. I believe the true odds of PacWest going out of business in the next few months are somewhat above 50%.

I'm picking on PacWest a bit, but the only reason we know about them is that they're based in Beverly Hills and have a lot of real estate developers and venture capital firms as customers. There are many other regional banks that have equally questionable underwriting on various real estate loans, and investors are likely to find out who they are in the coming months. The majority of regional bank stocks are worth holding, but investors really need to do due diligence on a case-by-case basis.

Why do I think the banking crisis isn't over, besides just that I think that there's an epidemic of dubious underwriting? Well, here it is. Deposits are falling.

Bank deposits are steadily falling, and are likely to continue doing so. The situation has been particularly acute at smaller banks.

Each week, the Fed publishes its balance sheet , where it reveals bank borrowings. Each week, the balance sheet shows that banks are borrowing more and more money from the Fed's bank term funding program. This brings us to the second problem, where looking at deposits alone is not enough to know if a bank is in trouble. Some banks will manage to stay in business by replacing their deposits paying 0% with CDs paying nearly 6%. If they have a lot of loans they made paying 3%, they're still in plenty of trouble, and investors will likely find out when earnings are released.

As for the US economy at large, fresh data on leading economic indicators shows that things are continuing to worsen , despite a buoyant stock market. At some point, this is going to hit. Treasury Secretary Janet Yellen keeps mentioning that more banks need to "merge ," while Fed chair Jerome Powell reportedly told a prank caller posing as Volodymyr Zelensky earlier this year that most Fed members expect a 2023 recession .

Bottom Line

Are TBTF banks worth buying? I believe some are "buys" for the long run, as well as their preferred shares. Regional banks are mostly "holds" due to depressed prices, with due diligence required on a case-by-case basis. For banks that have experienced runs and drama in the media, there is generally smoke where there is fire. These stocks are clear "sells".

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