WAL - Western Alliance: Excess Commercial Real Estate Exposure Should Not Be Overlooked

2023-06-18 06:29:51 ET

Summary

• Western Alliance Bancorp's deposit levels have improved, reducing its exposure to a "bank run," but likely lowering its future net interest income.
• Western Alliance may face increased loan losses due to its high exposure to the semi-frozen commercial real estate market.
• Western Alliance's unrealized securities losses are relatively small, but its potential unrealized losses on its mortgage loan portfolio may be over $2B.
• As long as its deposits remain strong, Western Alliance is at low risk of realizing significant losses on its loan or securities positions.
• If the bank faces non-performance in its CRE loans, it could see a significant book value decline as it sells its higher-credit quality assets (which have greater unrealized losses due to rising rates).

Over the past month, concerns regarding the stability of US banks have faded again as most banks see an improvement in deposit levels. Many of the most downtrodden banks have had strong rebounds, with Western Alliance Bancorp ( WAL ) rising by over 60% from its May low. Western Alliance has seen a great improvement after reporting a considerable surprise deposit growth of over $2B this quarter . Combined with the general improvement in stability across all banks, this change has dramatically reduced Western Alliance's immediate exposure to a "bank run."

However, when assessing the "challenged" regional banks, we must balance short-term prospects against long-term potential. One may reasonably ask, how did Western Alliance grow its deposit base so quickly while most of its peers have seen deposits decline? It was certainly not because of an improvement in market conditions, as the M2 money supply level (the primary macroeconomic deposit driver) has deteriorated since May. Instead, Western Alliance has rapidly expanded its savings account program, offering a high 5%+ APY account with essentially no minimum deposit - giving WAL nearly the highest-yielding account on the market today. Such a change will dramatically increase depositor account growth, particularly among smaller, more-insured accounts (middle-income households).

While this change improves WAL's immediate liquidity risks, it dramatically lowers the bank's potential income. Further, Western Alliance's assets are still almost entirely focused on real estate loans. In my view, the bank's exposure could cause an increase in loan losses (or expectations thereof) combined with a decline in net interest margins, harming the bank's cash flow. Its immediate "run risk" is low, but these two secondary risk factors may be sufficient to renew the bank's solvency risk eventually.

Risks Related to Real Estate Loan Exposure

Western Alliance ended Q1 with $71B in assets against $65.5B in liabilities. The bank had a total loan portfolio of $54B, of which $47B are held-for-investment. Around $14B of its "HFI" loans are residential, with the rest primarily commercial, with some smaller exposure to riskier construction and land development loans. The bank's loan-to-deposit ratio is on the high end of the typical range today at ~95%, while its CET1 ratio is on the lower end at 9.4%. That said, WAL's lower CET1 ratio largely stems from its higher exposure to real estate loans with higher risk weighting and lower exposure to "low risk" investment securities - ironically the primary driver of off-balance-sheet losses plaguing many banks today.

Still, like most US banks, WAL faces some off-balance-sheet losses due to its investment securities assets, totaling around ~$790M at the end of Q1 ($8.4B cost of HTM securities vs. $7.6B in fair-value following the bond market declines in 2022). Accordingly, adjusting its $4.55B tangible book value ( 10-Q pg. 63 ) for that loss, its "fair value" tangible book is likely closer to ~$3.76B , or ~$34.6 per share. Accordingly, WAL is not undervalued today based on its market-adjusted tangible book value per share, and is also not significantly cheaper than its unadjusted tangible book value.

Of course, off-balance sheet losses from securities positions are only relevant if the bank requires liquidity due to excess realized losses, a decline in deposits, or a decline within regulatory solvency minimums (or any combination thereof). Today, WAL's risk of deposit decline is low due to its very attractive savings account program; however, its real estate portfolio may eventually cause its loan losses to grow disproportionately.

As recently detailed in an article regarding Blackstone Mortgage Trust ( BXMT ), there is decent evidence to suggest that strains will continue to grow in office commercial properties and potentially spread to residential, hotel, and other commercial property market segments (due to a significant decline in economic activity in most US urban areas). Further, the sharp increase in interest rates may either lower the market value or increase the credit risks in both "non-MBS" residential and commercial mortgages, with falling valuations (particularly in commercial) pushing up loan LTV levels. Accordingly, there is great risk that WAL faces an increase in loan losses and a more-guaranteed risk that WAL is challenged by falling net-interest margins due to a significant increase in deposit interest costs.

WAL's expected loan losses at the end of Q1 were just 66bps of its funded loans (10Q pg. 59). That is a much lower figure than the bank has had in its history, with that ratio usually being over 1%. However, most banks have relatively low allowances for loan losses due to historically low default rates, which have persisted over the past five years, mainly stemming from extremely low-interest rates before 2020 (which allowed many homeowners and other borrowers to lock in at lower costs). Even assuming its residential loan book does not face increased credit risks, current events strongly suggest commercial loans (its particular largest asset segment) are likely to. As in the case of BXMT, commercial mortgage lenders with low LTVs may not be safe as property valuations collapse and the CRE property market freezes due to a sharp increase in borrowing costs. In the long run, I suspect that more of its commercial book will become non-performing. In the short-run, this growing risk factor may cause greater discounting of its held-for-sale commercial mortgage loans.

Another crucial figure is the high portion of Western Alliance's loan portfolio in fixed-rate long-term residential mortgage loans. In most instances, these are fixed-rate loans not backed by government agencies, originated over the past decade before the spike in mortgage rates last year. Western Alliance need not publish the fair value of these loans because they are not securities; however, the fair value of these loans is almost certainly well below their cost.

Estimating Unrealized Losses on Loan Book

At the end of Q1, the bank had $13.18B in residential fixed-rate mortgages due over 15 years ( 10-Q. pg 45 ), with a weighted average yield-to-cost of ~3.71% (10-Q. pg 65). The yield-to-cost of those loans implies they were likely made via origination or refinancing during the 2019-2021 time-frame when mortgage rates were below 4%; however, some may have been made before then. While we cannot make any specific estimation without more data (which is the bank's), I believe it is safe to assume that its unrealized losses on these loans are likely similar to those on its MBS mortgage portfolio (both of which being low-credit risk long-term fixed-rate residential mortgages).

From its 10-Q (pg. 100), we know that at the end of Q1, the bank's private-label MBS portfolio was worth $1,199M at fair value and $1,442M at amortized cost, or a 16.9% unrealized loss. Further, its GSE-backed MBS portfolio's fair value was $1,740M vs. $2,123M at cost or an 18% unrealized loss. Since the underlying assets of its residential fixed-rate loan book (non-MBS) are essentially the same, I assume its fair value is likely around 17% below its cost. A 17% unrealized decline in its $13.18B residential fixed-rate residential loan book is $2.24B, potentially wiping out most of Western Alliance's remaining "fair value" adjusted tangible book - previously estimated at $3.76B above.

The Bottom Line

If Western Alliance were to sell all of its securities and loans on the market today, I believe its net equity would be well below its current tangible book value. One factor is the known ~$790M unrealized loss on securities. The other is the unknown, potentially over $2B, unrealized loss on its residential mortgage loans. The bank's "fair value" of some of the bank's liabilities may be slightly above their initial value (on balance sheet), but I believe that impact would be minimal since Western Alliance's savings and CD rates are much higher than that of most banks. Overall, I believe it is fair to estimate that the "net liquidation value" of Western Alliance is likely below $2B, so I do not believe it would be a true value opportunity unless it falls below that level. Instead, WAL is trading at a premium to its tangible book value, which does not account for unrealized losses on either its securities or loan portfolio.

Now, I would only see a discount or value opportunity in WAL if it were trading below its liquidation value or had a very strong earnings outlook. On that note, I expect we will see a notable decline to WAL's income through a reduction in net interest margins over the coming quarters. Most of the bank's liabilities are savings account interest bearing liabilities, which had a 2.6% rate at the end of Q1 (10-Q pg. 65). Considering it is now offering over 5% APY savings accounts, it seems very likely that its NIM will be reduced due to a large increase in depositor costs. Indeed, considering the yields on most of its assets will not rise from the ~5.99% level in Q1 and its interest costs will, I expect its NIM may fall by 2% or more by year end (3.79% in Q1), erasing most of interest income. In short, it appears that Western Alliance is saving its short-term liquidity and solvency, while jeopardizing its earnings potential; however, that will not be proven until its Q2 and Q3 earnings are reported.

Overall, I believe that WAL is slightly overvalued based on its estimated liquidation value, decreased earnings potential, and its high exposure to a precarious commercial real estate environment. With that in mind, I am bearish on WAL; however, I would not bet against the stock because it lacks a clear negative short-term catalyst. The bank's significant unrealized loan and securities losses are unimportant for its immediate liquidity and will not harm its solvency if those positions are held to maturity; however, that will take over 20 years and interest rates may not fall back to extreme lows soon.

If the bank needs new money, potentially due to credit events in its CRE loan portfolio, or a new decline in deposits (which I doubt will occur due to its efforts to grow deposits), then the bank could be under greater strain. However, the credit risk in its positions with higher unrealized losses is extremely low, so that risk factor will only surface if the bank faces strain in other segments. Further, while a crash in the CRE financing market seems to be occurring today (potentially forcing WAL to realize its losses), it may be time before its loan losses rise, or it could avoid the strain if its loans are positioned better than its peers. In my view, these risks are significant enough to make WAL overvalued today, but not great enough to warrant a short position.

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