JPM - PacWest Bancorp: Heading Into An Uncertain Weekend

2023-05-05 12:44:55 ET

Summary

• PacWest Bancorp has seen its shares take another leg lower in the aftermath of the First Republic Bank takeover by JPMorgan Chase & Co.
• Uncertainty is very high, as the declining PacWest Bancorp share price may create a self-fulfilling prophecy here.
• Given this situation, uncertainty is increasing by the day, as some kind of receivership/takeover seems to be the most likely outcome here.

When the (regional) banking turmoil broke out in mid-March, I called the situation far too uncertain to get involved for many of these challenged regional banks, including PacWest Bancorp ( PACW ) .

As a smaller regional bank, the company felt the full fallout from the SVB Financial Group (SIVBQ) situation. Despite some actions taken by the government and FDIC, uncertainty prevailed.

The Problems

Banks at large face two issues. Banks were rich on deposits during the stimulus provided by the government to consumers during the pandemic, and when the Federal Reserve Bank started a historical aggressive rate hike cycle, banks were slow to raise deposit rates as a result of the initial situation.

This late response and the fact that deposits trail risk-free rates by a huge margin meant the deposit base of these banks saw outflows, while higher interest rates hurt the asset side of the balance sheet, creating concerns among depositors. This, in combination with the fact that banks offered sub-par deposit rates, simply created an unattractive proposition to depositors.

While banks had room (earnings power) to raise deposit rates, many could not raise these to the level of risk-free rates, and with deposits fleeing some banks were forced to sell assets which are underwater, creating huge holes in the capital base in the process.

A Look At The 2022 Results

Unlike some banks which have gone under, PacWest Bancorp has been a steady growth play but has not seen growth that is too strong in recent years, which is a positive in this environment. The bank posted a 2% increase in the asset base in 2022 to $41 billion, financed by $4 billion in equity, $34 billion in deposits, and the remainder in borrowings.

The company paid $118 million in interest on deposits in the fourth quarter, for an annualized 140 basis point expense, although banks typically have interest-bearing and non-interest-bearing deposits.

The bank held about $7 billion in investment securities (that is held-to-maturity and available-for-sale securities), on which it reported unrealized losses of $790 million. That is a big number in relation to the equity base but should be manageable. The bank had $28 billion in loans as well, and while these are not mark-to-marketed in the same way as the investment securities, realistic values are likely down to some degree as well.

Amidst the turmoil, PacWest Bancorp shares have fallen from about $27 per share to under $10 per share in the time frame of a few days. In comparison, the shares of the bank peaked at around $50 as recent as 2021.

The Crisis

During the regional banking crisis, which started with Silicon Valley Bank, the bank provided an update on its situation. PacWest reported deposits of $33.2 billion by the 9th of March, down a fraction from the $33.9 billion by year-end 2022. The company claimed sufficient liquidity, including nearly $2 billion in cash held on the balance sheet , as over $10 billion in liquidity from the Federal Home Loan Bank of San Francisco as well as the Federal Reserve Discount window.

This would be very welcomed as the bank revealed that $11 billion of the deposits are related to venture-related deposits, typically exceeding FDIC limits.

All in all, I concluded in March that this was an earnings issue at best, but it could be much worse, as there are few incentives for depositors to keep deposits with the bank, given the risks and subpart returns. The asymmetric risks and situation, did not make it interesting to hold equity in the bank as well.

Falling Along

Shares fell further to the $10 mark by Mid-March, and shares have been trading remarkably stable at this level until the start of May. As JPMorgan Chase & Co. ( JPM ) acquired First Republic Bank (FRCB) at the start of May, concerns on the fate of regional banks resurfaced and shares are now down to just $3 after losing half their value in the latest trading day.

Ironically, the bank released first quarter results in April, and shares hardly reacted to those results. An important number in the release was that unrealized losses on the investment portfolio actually shrank from $791 million by year-end 2022 to $736 million as interest rates ticked lower, due to the same banking crisis.

Total asset of the balance sheet rose from $41.3 billion to $44.3 billion, mostly as the company bolstered cash holdings to more than $6 billion as the loan book was stable, just like the investment securities portfolio.

Deposits fell from $33.9 billion to $28.2 billion, as the bank still reported a massive $7.0 billion in non-interest-bearing deposits. Instead, the company resorted to other borrowings as an impairment charge made that book value of equity fall to just $2.8 billion. That said, the overall tendency showed some kind of stability. This included the news that deposits had risen by $700 million from the end of the first quarter, halting the outflows, suggesting stability was seen.

Amidst the uncertainty in early May around the First Republic resolution, the bank felt forced to provide an update, telling the market that it is on track to sell a $2.7 billion loan portfolio (about 10% of the loan book). The bank furthermore indicated that the mix of insured vs non-insured deposits improved further to 75%, no deposit outflows were seen in the wake of over the First Republic news, as the bank even paid down a billion in borrowings out of excess liquidity.

And Now?

The reality is that shares of PacWest Bancorp have fallen to very low levels despite the intended comforting update made by the bank in recent days, and the weekend is approaching, meaning that investors should probably fear the worst.

That said, the hand-off approach by regulators and the Fed has received some scrutiny (for the right reasons) as this government strategy makes that the regional banking sector will collapse one by one. General uncertainty, rumors and perhaps even short-sellers pressure these bank stocks, as it would not be fair to compare the situation and also the strategy of the bank versus some peers who have seen hardship before (on the back of much riskier strategies).

An increase in the deposit insurance limit could prevent depositors from moving their deposits away from the regional banking sector, but it creates other (mortal hazard) issues as well. The current strategy - of doing nothing versus the status quo - results in massive asset and deposit concentration in the banking sector, as the regional banks will become much smaller as a whole. This has real repercussions in society, given the ties to local communities, but also the overrepresentation in certain lending categories.

Again, PacWest Bancorp does not control its destiny (entirely) itself anymore, as all options are on the table. This obviously is a concern for equity holders, but a sad conclusion as not all wounds are self-inflected by the banks involved at this stage of the crisis.

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