PACW - PacWest Bancorp: The Forest And The Trees

2023-05-03 09:17:03 ET

Summary

• PacWest and other regional banks have been lumped into a generic category of institution which is convenient when discussed in the media.
• The tendency to paint broadly ignores the unique attributes and considerations inherent to each regional institution.
• We take a broader view and explain why we don't consider PacWest to be in an entirely similar position to its more recently infamous peers.
• Uncertainty remains high and outcomes uncertain but we believe, on balance, PacWest is likely to survive although the interim could be painful.

PacWest Bancorp ( PACW ) has been the subject of extensive commentary (and perhaps even more extensive speculation ) over the past month in the aftermath of the failure of Silicon Valley Bank.

We don’t propose to relitigate prior arguments for or against the company since, in general, these have been thoroughly discussed and we refrain from writing on situations where we don’t believe we have something sufficiently meaningful to add to the conversation. However, we do wish to offer a measure of perspective on PacWest’s financial condition in comparison to its more recently infamous peers and explain our view that, in broad terms, PacWest’s situation is substantially different – and better – than those of Silicon Valley Financial and First Republic Bank ( FRC ).

In summary, we briefly review the banks uninsured deposits, the composition of current assets available to fund withdrawals, the company’s regulatory capital ratios under various conditions, the potential impact on operating income of various asset/liability scenarios, and ultimately our view that while the institution faces challenges those challenges are significantly different from other regional institutions and reasonably surmountable.

Uninsured Deposits

The first step in any assessment in the current environment is considering the bank’s deposit base. Deposits – and specifically uninsured deposits – are critical as they have been the focus and the impetus for the bank runs which have led to the liquidity concerns at the regional banks. It’s therefore important to have a rough understanding of the deposit situation as a context for the key concerns surrounding most regional banks. However, in the midst of the recent reaction to the takeover of First Republic, there remains a fair amount of dated and inaccurate information circulating in the market such as the following:

In the event we were wondering which banks are “next to be tanked by investors” – notwithstanding that depositors, not investors, “tank” banks via withdrawals – we’d certainly at least want to be working with readily available current information rather than dated information. We’d like to say this type of woefully misplaced “information” is limited to a small subset of commentators but in this case it’s coming from a Wall Street Journal reporter with 14,000 followers, many of whom we hope have the general wherewithal not to take this type of click bait hook, line, and sinker.

Spicy tweets, perhaps, but still financially irrelevant and only serving to fulfill the very definition of a tweet as a small burst of inconsequential information. Frankly, we’d expect more from Wall Street Journal reporters. It’s perhaps indicative of the tarnishing of what was once the gold standard of financial reporting but that’s a separate issue.

Regardless, the actual data point is far less concerning than the dated information above from a few months ago. PacWest, as of March 31, 2023, reported uninsured deposits per the Federal Financial Institutions Examination Council represented a mere 28% of the company’s total deposits after a significant runoff (and shift) in deposits during the first quarter. This places the bank’s proportion of uninsured deposits roughly in line with, or even below, the respective proportions at most typical community banks. PacWest, prior to the banking meltdown, was an outlier on the uninsured deposit metric but the significant shifts have resulted in the institution no longer being materially different from any other randomly selected institution on this metric. The only difference, perhaps, is the level of media attention.

However, that said, 28% of deposits still means an estimated $8.1 billion of the company’s deposits were uninsured at the end of the first quarter and conceivably remain at risk of withdrawal in a panic. The ongoing speculation about regional banks in general, and PacWest in particular, may amplify the potential for additional withdrawals of uninsured deposits but does not mean it’s a certainty.

Still, the company’s financial reports suggest that while deposits declined significantly through the end of the first quarter there was a roughly equivalent shift from uninsured to insured deposits within those figures. PacWest’s estimate of uninsured deposits as of December 31, 2022, was $17.8 billion against $34.3 billion in total deposits resulting in uninsured deposits representing 52% of total deposits. In comparison, at the end of the first quarter, uninsured deposits were estimated as $8.1 billion against $28.6 billion in total deposits resulting in the 28% figure. It’s notable that while total deposits declined during the first quarter by $5.7 billion – a not insignificant amount – estimated uninsured deposits declined by a larger $9.7 billion suggesting a rather significant shift within the bank to insured from uninsured deposit accounts. It’s impossible based on available information to assess the precise factors that contributed to or drove this shift but it is reasonable to suggest that a large contingent of existing customers modified their accounts to boost their deposit insurance protection but, importantly, did so while remaining customers of the bank. Ultimately, while uninsured deposits can reasonably reflect the magnitude of withdrawal risk in an institution, it is similarly true that an assumption that all uninsured deposits will flee any institution is likely overly pessimistic.

First Republic, after all, still estimated it held some $19.8 billion in uninsured deposits other than those made by peer institutions (accounting for 27% of total deposits) as of the end of the first quarter and well after the bulk of deposit flight had occurred across the industry.

Financial Position

In any case, let’s assume that nearly all uninsured deposits were withdrawn from PacWest. In this scenario the bank would have sufficient short-term liquidity to cover essentially all of those withdrawals without significantly impairing its regulatory capital ratios even when calculated – as we do – on an adjusted basis that does not conveniently ignore unrealized losses on investment securities.

PacWest reported $6.7 billion in cash on hand as of the end of the first quarter (including $6.3 billion on deposit with Federal Reserve Banks) as a result of an aggressive liquidity campaign in the midst of the turmoil in the banking industry. In combination with slightly more than $7.0 billion of investment securities (at the lower fair market value rather than amortized value) the combination of cash and investment securities are sufficient to cover the withdrawal of nearly all of the bank’s remaining uninsured deposits.

Granted, this statement requires some qualification since a meaningful portion of the investment securities portfolio is pledged as security for various advances and loans including those from the recently introduced Bank Term Funding Program. The program, broadly speaking, allows institutions to borrow against the face value rather than the fair value of certain government issued or sponsored securities. In factoring in the pledged securities which presumably could not be liquidated without repaying the associated loans, the potential coverage for insured deposits declines somewhat but still represents the vast majority - more than 80% - of uninsured deposits.

Herein lies a significant difference between PacWest and recently failed institutions. Unlike First Republic and Silicon Valley, PacWest has both sufficient liquid investment securities to cover uninsured deposits and the ability to sell those securities (in the process realizing associated losses) without significantly impairing its regulatory capital ratios. Arguably, this is the crux of the issue insofar as the regional banks when it comes to concerns about deposit flight.

The core issue insofar as Silicon Valley was that while the institution had a significant amount of investment securities available for liquidation to cover deposit withdrawals (and specifically uninsured deposits) it could not liquidate those securities without realizing losses that would effectively wipe out shareholders’ equity and render the bank severely undercapitalized from a regulatory capital perspective. In essence, the bank was caught in a Catch-22 scenario – it couldn’t liquidate the investment securities and remain solvent but it also couldn’t not liquidate the investment securities and remain solvent. Silicon Valley managed its way into an inescapable regulatory capital paradox.

First Republic’s position was a bit different in that the bank did not have anywhere near sufficient investment securities to cover the withdrawal of uninsured deposits (although liquidation would have similarly resulted in realization of significant losses and thus greatly impaired the bank’s regulatory ratios). Instead, the limited investment portfolio meant that First Republic had to rely on the liquidation of comparatively illiquid fixed rate residential mortgage loans - which had similar unrealized losses - to fund withdrawals. First Republic faced a severe liquidity crunch in addition to the regulatory capital paradox.

PacWest, however, faces neither of these conditions since, as noted before, the bank has both sufficient liquid investment securities to essentially cover uninsured deposits and the ability to sell those securities (in the process realizing associated losses) without significantly impairing its regulatory capital ratios. The comment bears repeating because of its central importance to our viewpoint.

Regulatory Capital Ratios

PacWest’s presentation of capital adequacy ratios makes adjusting the ratios to account for various factors a little more challenging than is the case with other institutions which provide more detailed calculations of their risk weighted assets and, more specifically, the capital under each regulatory ratio. However, it’s still possible to estimate these values and make the corresponding adjustments.

The full presentation of our adjustments is not presented here for brevity, though it may be the subject of a future article. In any event, our estimates indicate that even if PacWest were to sell the entire investment portfolio and recognize the full amount of current unrealized losses through the profit and loss statement and into shareholders’ equity for the calculation of regulatory capital ratios the bank would remain – even if just above – the regulatory ratios required to be considered a well-capitalized institution.

This condition is significantly different than would have been the case, as noted earlier, for such institutions as Silicon Valley, First Republic, and for others such as Republic First ( FRBK ) about which we have also written based on our view that the later institution is at significant risk particularly in the even of significant withdrawals of deposits.

PacWest is in a comparatively healthy financial position even under a distressed scenario relative to peer institutions which have received similar media coverage. In summary, we view PacWest’s financial position to be significantly stronger than is often suggested by market and media speculation about the company and regional banks in general due to the significant differences between the institutions and their asset/liability portfolios.

Choppy Seas Ahead

PacWest may be able to weather the immediate concerns but the immediate future will almost certainly be anything but pacific. The issue here lies not in the company’s ability to meet withdrawals and adequately maintain regulatory ratios, but the impact of the actions required to do so on the company’s net interest income and overall profitability. In this instance we find the likely outcomes not entirely dour yet also not exactly comforting.

In order to assess the impact of the company’s recent financing moves and the potential outcomes in the event of further significant withdrawals of deposits we constructed a net interest margin and spread model based on the company’s most recent financial statements and current applicable rates to certain known liabilities. In addition, we adjusted average balances to our projection of anticipated future balances to calculate forward expected net interest margins and spreads under various scenarios to determine the bank’s sensitivity to potential changes.

We do not present the full extent of our estimates and projections here but focus on three scenarios:

1. A stabilized situation which does not see significant additional deposit withdrawals while retaining significant cash liquidity in the near team as a buffer;
2. A drawdown scenario where substantially all of the company’s remaining uninsured deposits are withdrawn and met by using cash on deposit with other financial institutions and sales of certain investment securities; and
3. The above scenario assuming that all withdrawals are of noninterest bearing deposits.

Overall, our projections suggest a range of net interest margins between 1.4% and 2.0% on a going forward basis depending on the specific scenario and result in projected annual net interest income ranging from $420 million to $753 million. This range of values would suggest annual earnings per share in the range of ($1.40) to $0.75 per share with the highest distribution of outcomes concentrated around breakeven in the year ahead. The drivers in the short term, of course, are higher interest costs associated with the short term borrowing supporting the company’s current liquidity. However, in the longer term, the company’s existing cost structure is simply not compatible with a smaller balance sheet resulting from the runoff in deposits assuming that deposits are slow to return to the institution. PacWest will require time to adjust operating expenses to this lower net interest income reality though our projections so indicate that the differential is not so large that doing so would prove impossible or so painful that it would impair the core business. In any event, a period of subpar returns on average assets and equity is almost certainly in the company’s near to intermediate term future.

It should be noted, though, that these scenarios all assuming, at best, the status quo and no potential for improvement in the bank’s financial position or operating expenses.

Imperfections Exist

It should also be noted that all is not ideal at PacWest. In addition to the likelihood of reduced profitability in the near to intermediate term as noted above, the heavy concentration of the company’s investment securities towards longer maturities is something of an outlier in the broader community and regional banking sector and has exposed the company to significantly more unrealized losses on investment securities than would have been the case with a more balanced portfolio. We consider this to have been an error on the part of management not very dissimilar from those made by recently failed institutions. The mitigating factor is that the magnitude of that error was not nearly as large as in those other cases. Moreover, PacWest’s losses are largely already reflected as an adjustment to shareholders’ equity such that there are not significant unrealized losses “hidden” in the notes to the financial statements via held-to-maturity securities as opposed to available-for-sale securities. PacWest does have a block of held-to-maturity securities but, as noted in the company’s financial statements, as these were reclassified from available-for-sale securities a large part of the associated unrealized losses remained in the accumulated other comprehensive loss line on the balance sheet.

Moreover, we have not discussed the company’s loan portfolio and credit quality which is central to the company’s future operating results. The potential for additional loan loss reserves in the future should recessionary pressures boost loan delinquencies is real and would potentially aggravate concerns about future profitability. The speculation about the impact of a potential recession on credit quality is an open question and while losses – and reserves – will likely rise our view is that we’re not on the brink of defaults approaching those experienced in the last financial crisis. The composition of the loan portfolio and the company’s potential exposure to loan losses (and ability to manage those losses) is a wholly separate issue from the focus of this article and is left to future consideration.

Common Stock Dividend

It’s impossible to escape commenting on the company’s common stock dividend. A fair amount of commentary has been made about the company’s historical tendency to declare the quarterly dividend on the first Monday in May while the company – as of this writing – has yet to declare a quarterly dividend.

In our view, while the dividend should not theoretically be at risk from a purely financial standpoint we believe it is at risk from a perception standpoint. The significant decline in the company’s shares placed the anticipated dividend yield well into the distressed category and a reduction in the dividend, however temporary, would be a reasonable reaction to preserve capital in the face of potentially declining net interest income and net income. Indeed, we anticipate that a reduction in the dividend – perhaps to a penny share – rather than a full elimination would be both expected and prudent in the near term. This would reduce financial cash flow expense by around $120 million a year which may be necessary until the balance sheet can be adjusted sufficiently to ensure long term profitability in the face of short term compression in net interest margins.

The reaction to such a reduction in the dividend would likely be quite negative, at least in the short term, even though it would provide additional flexibility for the institution to adjust the core business to a new – and smaller – balance sheet for the foreseeable future.

Conclusion

PacWest is in a difficult position although not to the degree that is broadly perceived in the general media. The regional banks, whatever their specific financial condition and particular situations, are largely treated as a monolithic block or, at least, interchangeable components in the financial system with little differentiation. The lack of a more calibrated and nuanced perspective to each situation results in broad brush generalities which often lead, in turn, to broad brush outcomes.

Indeed, the potential for a self-fulfilling outcome certainly exists – the ongoing focus and speculation about stability may well lead to the withdrawal of insured deposits beyond uninsured deposits that would force the company into a liquidity crunch after the securities portfolio is fully liquidated to fund prior withdrawals. However, this strikes us as an exceptional scenario – possible, and perhaps amplified by the ongoing media and public obsession – but not necessary.

PacWest is differentiated from other troubled institutions in that it has a mix of assets and liabilities as well as a balance sheet that permits the company to avoid the liquidity and regulatory capital traps which recently brought down other regional institutions. Never say never, of course, as we may ultimately be proven wrong – the current uncertainty in the banking industry and volatility in the markets could lead to a loss of confidence that would bring down the institution regardless of the underlying financial position. In light of current information we believe PacWest is in a position to survive the current turmoil and revitalize its operations after a period of adjustment. The potential for a reduced dividend and a measure of capital dilution has led us to avoid the common shares in favor of the company’s preferred shares in which we have a position.

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