PACW - PacWest: The Risk Matrix Just Changed

2023-05-06 04:13:38 ET

Summary

• PacWest is said to be exploring strategic options after a massive bank panic caused the bank’s share price to drop 50% on Thursday.
• The bank panic occurred after First Republic Bank was put into receivership and later sold to JPMorgan Chase.
• The market is expecting PacWest to fail. I am downgrading my rating to sell.

Only a few days have passed since I submitted my work about PacWest Bancorp (PACW) to Seeking Alpha -- PacWest: A Top Bank Recovery Play For 2023 -- in which I discussed PacWest's deposit and liquidity situation. The community bank was heavily punished in March in the aftermath of Silicon Valley Bank's failure. What further added stress to the regional bank sector was the collapse of First Republic Bank at the beginning of the week. Although PacWest issued a new update this week in order to calm nervous investors, I believe that current developments don't bode well for PacWest's recovery potential and I admit that I made a mistake in buying the bank's common and preferred shares!

PacWest provides new deposit and capital update

PacWest issued a new update on May 4, 2023, which was meant to calm investors and assure the market that the regional bank, in the wake of First Republic Bank's failure, was not seeing extraordinary money outflows.

According to the update, PacWest said that it had total deposits of $28B as of May 2, 2023 compared to $28.2B at the end of the first-quarter. The regional bank further stated that the risk in its deposit base continued to decrease as the percentage of insured deposits further increased from 71% at quarter-end to 75% as of May 2, 2023. The insured deposit share as of the previous update (as of April 24, 2023) was 73%, so PacWest saw a 2 percentage point increase. As I already indicated in my last work on PacWest, the bank's deposit base stabilized in March and deposits flowed back to the community bank after the end of the first-quarter.

The bank took countermeasures to deal with heightened liquidity demands and announced that it was selling its Lender Finance portfolio for $2.7B, showing that management is committed to improving the bank's cash pool and shrinking its balance sheet. In relation to the announced asset sale, PacWest said that it expects its CET1 capital ratio, which is used to evaluate a bank's capital strength, to rise from 9.2% in Q1'23 to more than 10% once the sale is completed.

PacWest may have to explore other options as well as the market is clearly losing confidence in the bank's survival prospects. In my opinion, investors don't have a practical reason to be concerned and to zero in on the regional bank since the bank has more than enough liquidity to fund the withdrawal of all of its uninsured deposits: the uninsured deposit liquidity coverage ratio improved 8 PP to 188% as of May 2, 2023. This means that PacWest's liquidity situation continued to improve after the bank's previous update.

However, during periods like this the market is rarely rational. As a result, PacWest may have to raise equity capital from strategic investors, including the private equity industry, in order to ensure its survival. An equity raise would likely be highly dilutive for shareholders. In the worst-case, PacWest may also be sold to a larger, better-capitalized bank such as Bank of America ( BAC ) or JPMorgan Chase (JPM).

PacWest Bancorp's valuation

PacWest has seen a steep correction in its price-to-book ratio ever since Silicon Valley Bank failed, but in recent days the situation has become significantly worse. Due to its venture focus and high percentage of uninsured deposits until recently, the market zeroed in on PacWest as a potential candidate for a rescue operation. PacWest is now trading at a massive 84% discount to book value after the bank's valuation declined by 50% on Thursday. The market is clearly pricing in a failure of PacWest at this point.

Risks with PacWest Bancorp

PacWest is actually a well-managed regional bank with a strong liquidity and deposit base, but the market is currently not willing to acknowledge this. As a result, PacWest may be forced to either raise additional capital, which would dilute shareholders, or, in the worst-case, be sold to a larger top tier bank such as Bank of America or JPMorgan Chase. The risk matrix has therefore fundamentally changed this week and investors could lose the remaining equity value in both the common and preferred shares if the bank goes under.

Final thoughts

Buying shares of PacWest in the midst of a banking crisis, despite good reasons to do so, in my opinion, turned out to be a costly mistake. While I stand by my reasoning that PacWest is well-managed and that deposit flows have fundamentally improved, the market unfortunately comes to a different assessment. With the market panicking about PacWest's survival prospects, there is a good chance that the bank will either have to raise equity, sell itself or sell assets at a loss in order to further increase its liquidity. For those reasons, I am downgrading my rating from strong buy to sell!

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