PACW - PacWest: No Clear Path To Profitability As NIM Plummets Without Improving Deposits

2023-10-30 04:12:18 ET

Summary

• PacWest faces significant challenges in the banking industry, with declining earnings and negative income due to higher deposit borrowing costs.
• The bank struggles to maintain deposits and net interest income, leading to deposit outflows and potentially discounted loan sales.
• The deterioration of the US property market, particularly in California, poses additional risks to PacWest's loan book because it is highly exposed to that market.
• The merger of PacWest and Banc of California is not large enough to save the bank, particularly considering it will not materially improve its loan diversity.
• PacWest trades around 57% below its tangible common equity value but is not necessarily undervalued due to growing loan loss risks and likely chronically negative income.

PacWest ( PACW ) is one of the most critical regional bank stocks today. It is among those which have been pulled down by the various strains on the banking industry today. For most of 2023, it has been one of the closest banks to failure but has thus far avoided that route. The stock is down around 70% this year, with a 12%+ decline over the past month. I covered the company last June with a bearish outlook in " PacWest Bancorp: Sacrificing Most Of Its Income To Improve Stability." The company lost value last week since then after reporting a substantial decline in earnings with a 54% YoY sales decline and negative income.

As expected, the bank saw a massive decline in net interest margin due to increasing deposit borrowing costs. Despite that, the firm still saw declines in its deposit base; however, this was primarily offset by a reduction in outstanding loans through sales. The bank also faced a slight increase in its total allowance for loan losses, indicating a general decline in consumer and corporate credit stability, as we see on the macroeconomic front . This quarter, the bank is expected to complete its merger with Banc of California ( BANC ), with the deal likely to close at the end of November. This deal is expected to "save" PacWest by increasing its size; however, it will also increase its dependence on the Southern California market, potentially doing little to fix its core issue.

As the deal's closure nears and PACW and BANC suffer significant drawdowns, it is likely an excellent time to take a closer look at the bank to determine its investment potential. While most core problems remain, the macroeconomic situation today is different than it was when I covered PACW last. Other key issues include the bank's ability to generate a consistently positive income without losing more of its deposit and asset base. Beyond that, we must determine PacWest's fair value regarding potential unrealized losses and growing credit risks on its portfolio.

The Battle for Deposits is Not Slowing

Fundamentally, PacWest is struggling to maintain deposits and net interest income. Most larger banks, such as Bank of America ( BAC ), have substantial retail deposit bases, with most customers not looking to move their savings accounts for a higher APR. Thus, most huge banks have benefited from the interest rate increase because their loan returns have risen with the Fed's rate while their deposit borrowing costs remain near zero. Small niche banks such as PacWest, with more corporate and financially keen savings clients, have had to compete for depositors by increasing the rate on their accounts to over 5% . The bank's overall deposit borrowing cost was 2.98% in Q3 , up from 2.63% in Q2, but should continue to rise as CDs roll forward. Despite the massive decline in net interest income, the bank still faced deposit outflows last quarter. See below:

Compared to PacWest, Banc of California's financial situation is essentially stagnant. Like its larger peer, it has also faced a decline in deposits and net interest income, though not as significantly as PacWest. Even still, Banc of California's total deposits are hardly equal to the loss PacWest has faced this year alone, implying BANC is not large enough to improve PacWest's situation dramatically.

At the end of Q3, PacWest had a net tangible book value per common share of $15.64, down from $16.71 the quarter prior. That metric includes unrealized losses on held-to-maturity securities, a key culprit behind most of the banking woes in 2023. That issue expanded in Q3 and continues to grow today, given the revived sell-off in the long-term bond market. Accordingly, its common tangible equity value is ~$1.88B, about 5% of its total asset value. In reality, PacWest's solvency is better than that of many larger banks; however, its assets are far less diversified, its borrowing costs are much higher, and its real estate loan exposure is exceptionally high, giving it very challenging exposure to changes in the macroeconomic environment.

Notably, both PacWest and Banc of California have also seen their loans and securities-to-deposit ratios increase, as measured by long-term assets. See below:

Again, neither bank's ratio is alarming nor much worse than their normal historical range. That said, Banc of California has a relatively small deposit base compared to its loan portfolio, not necessarily aiding its value for PacWest. In that regard, I do not believe that two failing banks together make a strong bank, mainly because the combined size of both would still be far too small to make the bank "too big to fail" or give it " sticky deposits ," as seen in the largest banks.

Additionally, the fundamental situation harming smaller banks is not improving despite some efforts. Since spring, one aspect of the situation has improved because bank customers are unconcerned with lost deposits from a banking panic scenario. However, the "public emotion" factor can wax and wane with media attention. The core issue of a falling money supply and rising money cost continues growing. As the Fed reduces its assets (effectively deleting money created in 2020), the total money supply and bank deposit base dwindle. Additionally, as living costs increase and credit issues mount (student loans and auto), personal savings rates plummet, decreasing deposit growth. See below:

While it is unclear in the chart above, commercial bank deposits declined back toward the May minimum last week . In my view, that may result from student loan payment restart, removing a few hundred dollars per month in potential savings for many working people. This issue is also throwing yet another wrench into the property market by creating another barrier to buying for younger generations, potentially impacting the stability of making mortgage assets.

Property Market Risks Exacerbate Loan Book

One critical new issue facing PacWest is the deterioration of the US property market due to a massive decline in affordability. Significantly, over half of PacWest's property loans are based in California. Aside from its smaller securities portfolio, most of the bank's assets are various forms of California-centric property loans. The same is true for Banc of California . Thus, any issues in California's property market will likely have an added impact on PacWest.

By far, California has the highest home price-to-income ratios in the country, with most Southern California cities having 10-15X price-to-income ratios. That was somewhat sustainable when mortgage rates were around 3%, but the affordability has collapsed now that mortgage rates are about 8%. See below:

California home prices have slipped as a result of lower affordability. The decline stemmed over the summer as the impact of mortgage rates has not dramatically impacted the market due to its high inertia after 2020. Unsurprisingly, that has left southern California the worst place for first-time US-buying. Eventually, without support from new buyers, I highly doubt this market will sustain its prices, potentially leaving many recent buyers deeply underwater, thereby creating credit risks for PacWest and Banc of California. Of course, both banks are diversified between residential and commercial, but the commercial market is likely even worse than residential due to the added work-from-home impact.

The Bottom Line

On the one hand, PacWest is trading well below its tangible book value. Its stock price is just 43% of its book value per share, which accounts for both HTM and AFS unrealized securities losses but not potential unrealized loan losses (which could be realized as it sells to account for falling deposits), as well as heightened loan loss risks given the state of the property market. Its net interest income of $130M is minimal compared to its total operating expense of $110M, likely leaving the company with chronic losses. I expect that its interest costs will rise again in Q4 as its deposit costs continue to adjust for higher rates.

Thus, it may not generate a positive income until the Federal Reserve reduces interest rates. Currently, Treasury yields are around 5% through the 10-30-year range, meaning the bond market is no longer pricing material rate reductions. On top of that, the credit stability of its portfolio appears to be deteriorating due to the excessively high mortgage costs impacting the commercial and residential markets, likely lifting the LTVs on those loans by next year and potentially increasing defaults.

This is all occurring in a relatively decent economic environment. The consumer credit data is weak today, but overall economic growth was significant in Q3, albeit thanks to (unsustainable) inventories and government spending growth . Still, PacWest is performing poorly in a decent economic environment with solid employment levels. Should a recession result in higher unemployment next year, I do not believe PacWest's cushion is close to adequate, considering the combination of other factors impacting it. Further, though the upcoming merger with Banc of California adds perceived stability, I do not believe it will fix its core issues since that bank's balance sheet is potentially worse than PacWest's and does little to diversify it from the real estate lending market.

For these reasons, I remain bearish on PACW and believe it will most likely continue to lose value due to its inability to save its deposits without having negative income. Macroeconomic circumstances may also make its difficult situations much worse, particularly if higher borrowing rates and quantitative tightening remain vital factors. That said, although PACW has a high short interest of 15.4% and could certainly fail by next year, I would not short the stock. For one, it is well below its tangible common equity value, potentially making it an acquisition opportunity for a larger bank. Secondly, although I do not believe PacWest is "too big to fail," I personally do not want to be on the other end of government stimulus efforts, considering the Fed's (and Congress's) apparent willingness to bail out failing banks to improve public confidence.

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