PACW - PacWest Leads Fresh Regional Bank Rout: What's Going On?

2023-05-02 13:52:32 ET

Summary

• One day after the seizure and sale of First Republic, fresh panic is gripping the banking sector, with fears centered on Beverly Hills-based PacWest Bancorp.
• The timing is curious. The new rout comes after a period of calm and coincides with the Milken Institute Global Conference in Beverly Hills.
• PacWest's preferred shares currently indicate a high level of stress, but not an imminent collapse.
• The million-dollar question: Do the traders dumping PacWest know something we don't? Buying PacWest here carries an enormous adverse selection problem, so I wouldn't buy the dip.

After the FDIC seizure and sale of San Francisco-based First Republic (FRC) over the weekend, the focus has now shifted to Beverly Hills-based PacWest (PACW), which is leading an unusual regional bank rout early this week. As of my writing this, PacWest is down about 40%-50% over the last five days and is down about 70% year-to-date. PacWest is about one-fourth of the size that First Republic was and reported earnings last week . It appeared the situation had stabilized, although the bank had lost significant deposits during the initial phase of the crisis in March. The shares started to come under pressure yesterday, and the pressure has ramped up significantly today. Also coming under significant pressure are regional banks such as Western Alliance (WAL), Metropolitan Bank Holding Corp (MCB), and HomeStreet Inc. (HMST).

Why Is PacWest Suddenly Tanking?

It's not immediately clear why PacWest is falling so much and so quickly. PacWest is widely acknowledged to be among the weaker regional banks due to deposit flight. However, if you look at the preferred shares (PACWP), there isn't nearly as much stress indicated as there was in First Republic. I'm showing the preferreds trading for 40-50 cents on the dollar here, vs. First Republic preferreds which were trading for 10-15 cents in the days before its closure. There are a few possibilities for what's going on that are worth acknowledging.

1. It's a possibility that a lot of customers of PacWest decided to pull their money out after seeing the news on First Republic's seizure. I don't know if this is true but it would make some sense. This would explain why the stock began to fall on Monday - as this information gets more widely circulated the share price drop would accelerate. This is compounded by the fact that there's a major conference going on in Beverly Hills right now at the Milken Institute - if big money traders are finding out about deposit withdrawals or other issues at the bank then it wouldn't be illegal insider trading to act on it, per se (as far as I know). However, it's something that someone like me at home in Texas is not going to know about until it's too late. This is a huge adverse selection problem! If you're buying PacWest here, there's a decent chance that the people on the other side of the trade know something you don't.
2. There's some possibility that false rumors are circulating this week about regional banks, either from short sellers or just random people on social media. The problem, if you're long, is that these things can tend to be self-reinforcing. Social media makes bank runs faster and much more dangerous, so the very fact that this type of stuff can happen is a good reason not to own shares in a struggling bank.
3. Of course, it could be much ado about nothing, but there's big money changing hands right now in PacWest and other regional bank stocks. Either big traders know something that small traders don't, or the big traders are bluffing to make money. Either way, it's not a great scenario to be caught long.

Game Theory and Regional Banks

I touched on this a bit, but something very important to keep in mind in trading is the concept of adverse selection . This comes up all the time in economics, whether you're buying a used car, buying life insurance, or even using a dating app. The basic idea is that the other party in the transaction may know something you don't and can use it against you.

If you're buying a used car, the dealer knows everything that's wrong with the car, while you don't. How much do you pay? This is known as the "lemon problem" in economics. Similarly, if you're unhealthy, you're likely to inflict losses on your life insurance company, so you should try to buy as much life insurance as possible. The problem with buying regional bank stocks here is that you're often trading against people who are much better informed than you, so they have a large advantage in trading against you. To this point, it's nearly impossible to win taking shots on regional banks without first-hand information on how the banks themselves are doing.

The second piece of game theory that you should keep in mind is the infamous prisoner's dilemma . It comes into play here with regional banks because doing what's good for you individually is bad for the collective. This creates an unstable equilibrium and leads to more banks failing than would otherwise. This unstable equilibrium is definitely in play for PacWest - their customer deposits are >99% likely to be covered by the government, but there's no upside for leaving their money in. If you're under $250,000, then you should leave your money in banks like PacWest because the FDIC is guaranteeing you, and because doing so is a "prosocial" thing to do. However, if you're the CFO of a company that has $25 million in cash, you're better off not risking your career on an implicit government guarantee for keeping your deposits in PacWest, First Republic, or any similar bank.

Bottom Line

It's tempting to want to buy the dip in PacWest here, but the odds that someone knows something we don't about the bank are fairly high. For these reasons, I would sell PacWest stock here. The preferred shares are more interesting because PacWest is not necessarily doomed like First Republic was. It's a close call, but you might get away with holding the preferred shares, although I personally would sell those as well. If you're set on buying PACW common stock, I would choose the preferred shares instead for some extra protection. As for the Fed, they're likely still hiking tomorrow.

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