WAL - PacWest Bending But Shouldn't Break

2023-03-14 10:27:27 ET

Summary

• PacWest has come under severe pressure, as the market fears a run on deposits similar to SVB and an un-survivable squeeze on liquidity.
• Tech companies make up a significant percentage of PacWest's deposits, but the U.S. government has thus far backstopped both insured and uninsured depositors.
• Unrealized mark-to-market losses are a meaningful percentage of tangible common equity, but a new funding facility should eliminate the need to sell securities to raise funds.
• Management was already slowing loan growth and reprioritizing around its core community bank lending operations.
• I believe PacWest survives this liquidity squeeze, but there will still be consequences from lower loan growth, higher funding costs, and increasing credit losses.

As of this writing (before the market open on March 14), it looks like regional banks are poised to snap back sharply as fears over liquidity and deposit runs seem to be easing in response to concerted government actions and banks successfully tapping sources of liquidity since the failures of SVB (SIVB) and Signature (SBNY). As one of the worst-hit banks, PacWest ( PACW ) looks to be one of the sharper rallies on Tuesday morning if pre-market indications hold up.

When I last wrote about PacWest , I noted that the company was facing some near-term challenges from higher deposit costs and a decision to reposition the business toward more profitable and more sustainable lines of business. With what’s going on now in the banking sector, management’s decision to shift more of its focus to relationship-based community banking (versus equity/venture banking) looks even better, though clearly the liquidity situation is now much more on investors’ minds and the funding cost risk is likely to loom even larger.

There are definitely aspects to PacWest’s financials that don’t look so good now, but I do believe the bank will make it through this crisis. I do offer the caveat, though, that SVB in particular has underlined the risk that almost any non-systemically-important bank faces – if the market loses confidence and depositors rush to pull their deposits, there’s not much that can be done to prevent collapse.

Are PacWest Depositors At Risk?

I expect many readers will have questions about PacWest along the lines of, ”is my money safe at PacWest?”, or “is PacWest going to collapse?”, and “should I take my money out of PacWest?”. All of which are understandable given the chaos and headlines of the past week or so.

To address the first question, I believe the U.S. regulatory infrastructure (via the Fed, FDIC, and U.S. Treasury) have made it clear that they will step in to stomp out the risk of systemic panic where they can. Fully guaranteeing both the insured and uninsured deposits of SVB and Signature was a big move in that direction, and with that precedent established, I believe it would be difficult to back away now and let the uninsured depositors of a bank like PacWest twist in the wind if the bank were to go into receivership.

How much of an issue that should be with PacWest is debatable. As per its call reports, PacWest’s ratio of uninsured deposits is higher than average (52% versus the low-to-mid-30%’s), but not as high as Signature (almost 90%) or SVB (86%), nor as high as First Republic ( FRC ) (68%). On the other hand, about a third of PacWest’s deposits are in the tech vertical (venture-backed companies and so on), and it seems as though VCs advising their portfolio companies to immediately pull their deposits from SVB played a not-insignificant role in that bank’s collapse.

PacWest put out a press release on March 10 stating that deposits as of March 9 stood at $33.2B versus $33.9B at the end of Q4’22, but it is certainly possible that deposits have fallen further since then, particularly if companies worried about their uninsured deposit exposure moved money out of PacWest subsequent to that release.

Is PacWest At Risk Of Collapse?

Before going into the numbers and discussion of whether PacWest is at risk of going into receivership, I want to again reiterate the caveat that there’s only so much you can do with publicly-available information and analysis. I don’t have the bank’s balance sheet as of yesterday, nor do I know what is going to happen in the market this week and how deposits may respond to it. As seen with SVB and Signature, panic can do a lot of damage.

That said, I think PacWest will make it.

One of the big issues with SVB was that the bank had pursued an aggressive growth strategy, pushing its liquidity to the limit in pursuit of asset growth. Unfortunately, the bank aggressively added low-coupon assets ahead of a meaningful rise in rates, leading to significant unrealized losses in the securities portfolio (and loan portfolio), while spreads were under pressure from relatively low earning asset yields and fast-rising deposit costs.

PacWest has comparatively lower securities exposure, at a little less than 21% of Q4’22 earning assets versus almost 60% at SVB. With that, unrealized losses on the securities portfolio were about 47% of tangible common equity at the end of the last quarter – certainly higher than you’d like, but far less than the nearly 130% at SVB.

As far as liquidity metrics go, cash to earning assets is a little better than average (around 5% using the most recent update from PacWest management), and the ratio of loans and securities to deposits was about 106% versus a midcap average closer to 110%, and around 115% for First Republic and Western Alliance ( WAL ).

I also believe that the new Bank Term Funding Program is a relevant factor to consider. In the wake of the two bank failures, there is now a facility available that will make loans to banks of up to one year at the overnight indexed swap (or OIS) rate plus 10bp, with banks putting up their U.S. Treasuries, mortgage-backed securities, and similar qualified assets as collateral. Importantly, the facility is valuing the qualifying assets at par, meaning that banks do not have to sell at significant mark-to-market losses to boost their funding.

PacWest also has a different earning asset make-up. Clearly there is exposure here to mark-to-market losses in the securities portfolio, but PacWest has done comparatively less lending at lower yields (mortgage loans, etc.) and has more rate sensitivity in its loan portfolio by virtue of its C&I and CRE exposures. Granted, there is credit risk exposure here (particularly in the CRE and construction portfolios), but any credit issues there are likely to emerge over time and not as a concentrated event.

The Outlook

I do believe that PacWest is looking at elevated risk relative to a “typical” midcap bank, but I think the risk is more likely to materialize through weaker earnings. PacWest is likely to look to build up its deposit base further, and that will entail paying more for deposits. I also would expect to see more long-term debt funding (to add an extra layer of security), in addition to FHLB advances and other sources of liquidity. At the same time, I expect that management will look to accelerate the plan to slow its lending, and particularly in non-core areas.

What this all means to me is likely less growth in earning assets (slower loan growth) and weaker spreads (higher funding costs). That, in turn, will drive lower pre-provision profits and core earnings, particularly with provisioning expense likely to increase from here.

Modeling always involves guesswork, but modeling PacWest today involves even more guesswork given uncertainty on the make-up of the financing/liquidity that management will bring onto the balance sheet, the pace of loan growth, and so on. Still, I’m making a best-efforts attempt to model this, and my ’23 EPS moves from $3.65 to $2.49, while ’24 EPS moves from $3.59 to $2.82. There could very well be large changes to these numbers after Q1’23 earnings, when I expect management to update their guidance.

Boosting my discount rate to account for increased near-term liquidity risk, my fair value on long-term core earnings declines to about $23, and I get to $18.50 using a 7.5x multiple on my ’23 EPS. Whether 7.5x is appropriate (I was using 9x before) is certainly debatable, but readers can take that $2.49 number and adjust the multiple as they wish.

The Bottom Line

If pre-market indications are accurate, there’s still a large gap between that $18.50-$23 range and the $15 or so opening price. Clearly the market is still very nervous about PacWest, and I certainly acknowledge that my new estimates for ’23 and ’24 could be well wide of the mark. That said, provided we don’t see another shock to confidence and liquidity, I think PacWest can navigate through this treacherous period and survive, and given the nature of the core business, I do think a $20-plus fair value is valid over time, as PacWest would need only 3% to 4% long-term growth to get there.

For further details see: