PACW - PacWest Bancorp: Sacrificing Most Of Its Income To Improve Stability

2023-06-25 03:45:13 ET

Summary

• Regional bank stocks have seen partial recoveries after a wave of losses in March and May, but most declined by around 10% over the past two weeks, indicating a bearish trend.
• PacWest Bancorp is perceived to be next on the "chopping block" due to its high concentration risk in real estate assets and off-balance sheet securities losses; however, it has a low immediate risk of insolvency or liquidity issues.
• Despite this, PacWest may face near-zero or lower income levels by Q4 due to aggressively increasing borrowing costs to attract depositors, ongoing declines in property valuations, and high leverage levels, making it a high-risk investment in the long run.
• Although I am bearish on PACW, I would not bet against the stock due to its potential NAV discount and high short interest. However, Bank of America may be a more suitable strategic short today.

Bank stocks were struck by a large wave of losses in March as a few regional banks saw massive deposit outflows, leading to their rapid demise. That volatility was followed by around six weeks of calm, eventually culminating in another wave of losses in early May which led to the collapse of the larger First Republic Bank. After that, many regional banks' stocks have seen partial recoveries, having been relatively stable for the past six weeks. That said, the regional bank SPDR S&P Regional Banking ETF ( KRE ) has stagnated over the past month, declining by around 10% over the past two weeks. In my view, this may be an initial indication that at-risk banks may face another wave of trouble over the coming weeks.

Among regional banks, the next on the "chopping block" is usually perceived to be PacWest Bancorp ( PACW ). PacWest's situation is similar to that of Western Alliance Bancorp ( WAL ), which I recently covered in " Western Alliance: Excess Commercial Real Estate Exposure Should Not Be Overlooked ." PACW's key risks are essentially the same as WAL, yet they are more pronounced due to its extremely high concentration risk in real estate assets combined with its off-balance sheet securities losses. Like Western Alliance, PacWest has potentially halted the decline in its deposits by dramatically increasing deposit and CD rates to an APR of over 5% (20X higher than the national average). Given this, as in WAL, PacWest's risk of losing deposits is likely extremely low, and the insured portion of its insured deposits is likely rising quickly.

This change essentially eliminates its "bank run risk" but effectively ends its profitability. Additionally, as long as the total US money supply continues to fall, all banks will face negative strains on their liquidity and solvency. I believe PacWest's efforts to encourage deposits and sell its riskiest assets will ensure its short-term solvency but fundamentally impair its permanent value. Eventually, recovery may occur; however, I believe there is still reason to think that PACW is overvalued today.

What is PacWest Worth Today?

PacWest is among the many banks with significant unrealized securities losses. This issue plagues almost all banks since many purchased Treasury and MBS bonds in 2021 at extremely low-interest rates, now seeing those assets are worth 10-30% less. Since PacWest (and peers) plan to hold these assets to maturity, they need not realize those losses. However, most of those assets will not mature for over fifteen years, so if they face negative deposit trends or other loan losses, they'll be forced to sell these securities at significant losses. Thus, regarding the "at risk" banks, I believe investors should consider the actual liquidation value of these banks far more than their "book value."

At the end of March, PacWest's held-to-maturity securities book had an amortized cost of ~$2.28BB, with a fair value of ~$2.16B. The total unrealized loss was $117M . Notably, most of its held-to-maturity securities have a maturity length of over ten years, so the duration risk of its securities portfolio remains high. Should long-term rates decline, requiring a significant decline in inflation, then it could reverse much of its unrealized losses. However, keeping in mind long-term rates remain well-below current inflation levels, it remains possible ( and, in my view, likely ) that long-term rates rise even higher - potentially impairing its securities portfolio further.

More importantly, PacWest had a total real estate loan portfolio of around $20B, most concentrated in residential mortgages ($6B), but with ample exposure of $4.6B to construction and land loans - the riskier mortgage segment. The rest of its portfolio is commercial and multifamily, which carry elevated credit risks given the massive declines in US commercial property values (and the considerable decline in transaction volumes this year). At the end of Q1, ~78% of its total loan portfolio was in real estate, far above that of most banks today and well above the Federal Reserve's guidelines .

Additionally, from its last 10-K , we know that over half ($8.8B) of its $15.2B real estate mortgage portfolio is due after 15 years. Of its mortgage portfolio, nearly 40% ($5.72B) were fixed rate. Accordingly, some portion of its loan portfolio falls into the "long-term fixed rate" category, meaning those assets' "fair value" is almost certainly well below their amortized cost, given the significant rise in mortgage rates last year. The company does not provide sufficient data on its loan book to estimate the fair value of its loan portfolio effectively. That said, I suspect its fixed-rate long-duration loans (likely around $2-$3B of its assets) are likely worth 10%+ less than their amortized cost, as is the case with its securities mortgage portfolio. Thus, while we cannot give a specific estimate of this factor, investors should be mindful that its loan book would likely be sold at a discount in the event of liquidation.

Long-term interest rates are also around 40bps higher today than on March 31st, meaning the fair value of its assets has declined further since then - though not by as much as it did in 2022. I estimate that PacWest's liquidation value is likely around $2B today, based on adjustments from unrealized losses; however, it may be well below that figure if it had significant deposit outflows in May ( likely around 10% or more ). Still, I believe that PacWest is technically trading at a discount to its liquidation value; however, a slight change in circumstances could quickly erase its remaining equity.

PacWest's Abysmal Earnings Outlook

Like Western Alliance, PacWest has essentially transferred its balance sheet risks to its income statement. If it did not raise deposit borrowing costs significantly, its deposits would likely have fallen further, forcing it to sell even more assets at a discount. The bank also sells much of its construction loan book to Kennedy-Wilson ( KW ). These loans had a $200M discount or around 8.5% of their initial value , pushing PACW's "liquidation value" around $200M lower. I think it will be imperative to watch for discounts in the real estate loan market because if discounts remain this large, then PACW's liquidation value could easily be zero. Of course, that is unlikely today because the discount was likelier only so large due to the riskier nature of PACW's construction book (and lackluster demand for risk from other banks).

Assuming this deal closes, PacWest will lose much of its most profitable lending segment, having a yield of 8.6% . Of course, combined with an expected increase in deposits, this change should push PacWest's balance sheet back into Federal Reserve guidelines and significantly improve its CET1 ratio. However, I expect PacWest will lose most of its income from this change, jeopardizing its long-term value and stability.

At the end of Q1 (10-Q pg. 68) , the total effective yield of PacWest's interest-earning assets was 5.35%. I suspect its interest revenue will fall by around $215M after the completion of its $2.6B deal (assuming an 8.6% yield), likely pushing the total yield of its interest-earning assets down to around 5% (accounting for the decline in interest income and interest-earning assets). More importantly, its interest costs are likely to soar. In Q1, around a third of its deposits were from interest checking accounts, paying a 3.2% average rate. Around 30% came from the money market and time deposits, with yields of about 3% (2.5% for the money market and 3.4% for time). Only $600M, or 2.7%, of its deposits, were from savings, paying a low rate of 41 bps. The bank's total interest-bearing deposit costs total 2.9% at the end of the quarter, or around 1.5% below the average one-month Treasury rate at that time.

At the end of the quarter, the company's major initiative was to expand its insured savings account book and CDs. Since the bank currently offers savings accounts and CDs at the one-month Treasury rate of ~5.2%, the "gap" between its deposit costs and the Treasury cost (or LIBOR) is likely converging toward zero. Most of its non-deposit interest costs will also rise at the same pace as the base rate. Additionally, I expect the bank will lose much of its $10.2B in non-interest-bearing demand deposits last quarter ( $14.4B in Q1 of 2022 ).

Not accounting for the last Fed hikes (which benefit most of its assets equally), I suspect its effective borrowing costs will rise by 1-2% over the Q2-Q3 timeframe, given that it has likely "closed the spread" on its savings and CD rates compared to Treasury rates. If its non-interest-bearing deposits are still sliding, the potential increase in borrowing costs could be considerably more significant. Again, that is not accounting for the rise in the base rate since March, just because it's offering CDs and savings rates equal to the base rate when it was around 1.5% lower before March. Of course, it will take around a year for that full effect to be seen as its lower-rate CDs expire. Still, combined with the sale of its high-yield construction loans, I believe the bank will likely lose all of the 1.88% net interest essentially spread it had in Q1 (3.3% in Q1 of 2022). Suppose it loses its non-interest-bearing deposits (which I suspect, given the circumstances and the figure's trend). In that case, it should also erase most of its 2.89% net interest margin (as its NIM closer reflects the interest spread).

The Bottom Line

In my view, PACW has a low immediate risk of insolvency or liquidity issues because of its dramatic efforts to expand its deposit base and its sale of at-risk assets. That said, I believe it will lose nearly all of its net interest income due to aggressively increasing borrowing costs to attract depositors. While it is not possible to definitively project its net-interest margins, the apparent decrease in spreads from CDs and savings accounts to the base rate. The bank also has no sustained source of non-interest income, which was $90M TTM (compared to $1.26B TTM in net interest income). Its total non-interest expense was $760M TTM and is consistently around that level. Thus, even if PacWest does not lose all of its net interest income, I believe it will likely lose enough to erase all of the ~$600-$700M annual net income it had in recent years.

I suspect PacWest will not post such a significant income decline in Q2 since its CD and savings rates will not have fully adjusted to the increased APR level by then. However, by Q4, I believe PacWest may be stuck with chronically near-zero or lower income levels. The bank's plan is likely to decrease savings and CD rates once its deposit levels are finally stabilized; however , given the accelerating decline to the M2 total US money supply (driven by the Fed's QT), I do not believe it can avoid competing for depositors until the Federal Reserve makes a significant dovish pivot.

Much of its lending portfolio will remain in commercial real estate assets, which I believe have significantly increased risk due to the ongoing declines in property valuations. Thus, while a recession could encourage the Federal Reserve to take dovish steps, it would also increase PacWest's loan losses. Due to PacWest's high leverage level and tremendous property loan exposure, it would only take a moderate rise in real estate loan losses (or discounts on its portfolio) to erase most of its remaining equity.

Overall, I am bearish on PACW today; however, I would not short the stock for a few reasons. In my view, based on the data available, PacWest has relatively little immediate insolvency risk compared to its position two months ago because it sold its high-yield assets and encouraged deposits by significantly increasing rates. Thus, PacWest's immediate solvency should be fine unless there is a vast systemic increase in commercial property loan losses. However, I believe it is sacrificing all (or more) of its TTM income to stabilize its balance sheet, thereby offering no sustained value for investors. Further, should its net interest income fall sufficiently, it should still eventually lose its existing capital through negative operating income, mainly if a dovish pivot does not occur by 2024-2025. Thus, I believe PACW is still at a high risk of bankruptcy in the long run but not in 2023 (given no increases in loan losses and continued deposit stability).

PACW is likely trading at a ~50% discount to its liquidation value in the immediate horizon. PACW also has an extremely high short interest of 25%. These figures give it ample potential to rise higher on a short squeeze. Should PACW rise to the $12-$17 level on a squeeze, I may short the stock as its market cap grows closer to its liquidation value. However, if banks become sour again, I am more willing to short the larger banks like Bank of America ( BAC ), which I believe is far more overvalued today than PACW .

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