2023-05-31 13:22:33 ET
Summary
- Washington Trust has sold off with the rest of the regional bank category. While this tempts us to think of WASH as a potential bargain, some digging reveals otherwise.
- Washington Trust has some unrealized losses in its debt securities portfolio, though it does not exhibit any risk of suffering from bank runs fueled by large depositors in my view.
- Competition in deposit rates, however, is a concern, and given where rates sit, there is room for protracted deposit rate competition across US banks for a few years.
- The earnings announcement for Q1 2023 cited deposit competition as a headwind to earnings.
- The stock is currently priced for a dividend cut. Do not feel too tempted by the fat 8.5% dividend yield.
We all know the recent headlines about banks. Three larger US banks have departed from the ranks - Silicon Valley Bank, Signature Bank, First Republic - for reasons related to the recent Fed rate hikes. The market is currently quite spooked about the issues common to these banks, as well as the entire regional bank category.
The above is a plot of the price of KRE (tracks regional banks) and Washington Trust (WASH) - since WASH is a regional bank, it has tended to follow the trajectory of its general category. However, it may not be true that WASH suffers from the same issues as the whole category, and is just run down with the crowd.
The two issues salient to regional banks regarding this sector wide bear market that I will cover regarding WASH are:
- Unrealized losses in its debt securities portfolio, and
- Percentage of uninsured deposits
Unrealized Losses in Debt Securities
When banks cannot find good loan issuance opportunities to absorb an influx of deposits, they can choose to invest that money in interest paying securities, usually treasury securities or mortgage backed securities. The rub is that by investing in these securities, they expose themselves to the interest rate (and to a lesser extent) the credit risk inherent in these securities.
The key word here is duration : a measure of interest rate risk, as a function of the time until maturity or amortization period of the security. The longer the maturity of the security, the more its market price decreases in response to increases in how the market prices its yield.
This means that since deposits may be withdrawn at any time, a bank should ideally want to invest its deposits into debt securities of very short duration, and/or hedge them too. In an ideal situation, a bank should want to buy something like T-bills of below 1 year maturity to invest its deposits in, to protect itself against damaging losses caused by having to sell its investments at an awkward time to get the cash to make good on withdrawals.
Silicon Valley Bank's Epic Failure
This is where Silicon Valley Bank failed, miserably. Let me show you the relevant bits of its most recent 10-K filing, from Feb 2023, describing its situation as of Dec 31, 2022. Let's begin with its balance sheet:
SVB Balance Sheet - Assets (2022 10-K Filing, EDGAR)
There's a quirk in how the accounting works here. Available-for-sale securities are marked to market - their values on the books are whatever the market says they are now. However, Held-to-maturity securities are held on the books at cost. This means that for held-to-maturity securities, their market value can deviate substantially from the value they are held on the books at.
Boxed in red are asset values on Dec 31, 2022. SVB's available for sale securities were worth $26B at market prices, but originally cost $28B. More egregiously, SVB's held to maturity securities were worth $76B at market prices, but originally cost $91B. We can reach this damning conclusion about SVB's risk management:
SVB's debt securities lost $17B in market value due to the Fed rate hikes in 2022, while SVB's market capitalization at the start of 2022 was $14B!
A quick dig into SVB's 2022 10-K illustrates the reasons quite clearly:
SVB's Securities, Available For Sale
SVB Securities - Available For Sale (2022 10-K Filing, EDGAR)
SVB's Securities, Held To Maturity
SVB Securities - Held Until Maturity (2022 10-K Filing, EDGAR)
As you can see, SVB's available for sale account contained securities whose maturity is on average significantly greater than 1 year. Its held to maturity account is almost entirely composed of 10+ year maturity securities. For the uninitiated, a 10-year security has approximately 10 times the interest rate sensitivity versus a 1-year security. This enormous concentration of duration risk explains why SVB was essentially insolvent by end of 2022 and was essentially a walking zombie in early 2023.
Let's pivot over and look at Washington Trust.
Washington Trust's Burned Hands
Let me show you the relevant bits of WASH's most recent 10-Q filing, describing its situation as of Mar 31, 2023. Let's begin with its balance sheet:
WASH Balance Sheet - Assets (Q1 2023 10-Q Filing, EDGAR)
Boxed in red are the Mar 31, 2023 values. WASH's security portfolio was valued at $1,054.7M at mark to market prices, but it was purchased at a cost of $1,209.8M originally. The effect of the recent cycle of rate hikes was to cause WASH's security portfolio to depreciate by about $150M . Note that WASH's market capitalization as of end of 2022 was $800M .
WASH's situation isn't quite as extreme as SVB's, but it is definitely a big chunk of its market capitalization. Again, let's see what WASH was invested in, looking at the Notes to the Unaudited Financial Statements:
WASH Securities By Maturity (Q1 2023 10-Q Filing, EDGAR)
Again, just like SVB, we see a very substantial amount of duration risk in WASH. In terms of the proportions, about 90% of its securities mature in 1 year or more, and 50% of its securities mature in 5 years or more. This is one of the two major reasons why WASH currently trades at a discount - the stock market is pricing WASH based on the market value of its securities portfolio.
Is this unrealized loss going to widen in the future?
FOMC Dot Plot, March 22, 2023 (Federal Reserve)
The FOMC Dot Plot is a graph of the interest rate expectations of the Fed officials. This graph is from March 22, 2023. Notice that it has a downwards slope, indicating that the Federal Reserve officials tend to think that interest rates have approached a short-term peak, and will go down. This means that unrealized losses should slowly decline, as market yields normalize with respect to the purchase prices of the securities.
So, the prospect for further unrealized losses looks muted.
Uninsured Deposits - Muted Bank Run Risk
Silicon Valley Bank, Signature Bank, and First Republic all had something in common: large deposits that were substantially uninsured by the FDIC. Normally, a large concentration of such deposits was not a worry, but given the Twitter and social media-connected world, fear can fly through and infect a crowd in a jiffy.
Back in March, S&P Global compiled a list of top banks by uninsured deposits. SVB, Signature Bank, and First Republic are all on that list:
Adapted From S&P Global Market Intelligence (S&P Global Website)
Since events have unfolded that would make this March 13 chart out of date, I have updated the graphic to conform with the situation as of today. SVB, Signature Bank, and First Republic bank had uninsured deposits equaling 93.8%, 89.3%, and 67.4% of all assets. Additionally, other two banks not in the news so much - MUFG Union Bank and Bank of the West each had a 53.0% and 50.7% respectively.
It would seem like 50% is a threshold that signals danger. Where does WASH stand in this respect? I'll show you a portion of its 10-Q filing for Q1 2023:
WASH Uninsured Deposits (Q1 2023 10-Q Filing, EDGAR)
WASH had $6,859M in assets as of March 31, 2023, so as a percentage of total assets, uninsured deposits are 15.6% . This number is quite far away from the 50%+ figure for banks that suffered bank runs.
So, the risk of a bank run triggered by large depositors seems very muted for WASH.
WASH's Valuation & Latest Earnings Release
WASH is currently trading favorably in two valuation measures: price to earnings ratio and price to tangible book value ratio. At 1.118x tangible book value, WASH would appear to be a steal, all else being equal.
However, let's take a quick peek at its latest earnings press release .
Our capital, liquidity and asset quality remain strong, yet first quarter earnings were dampened by continued margin pressure resulting from rapidly rising funding costs and increased competition for deposits ," stated Edward O. Handy III, Washington Trust Chairman and Chief Executive Officer. "We remain confident in our business model, the strength of our balance sheet, and our ability to manage our way through these challenging times. We recently opened a branch in Barrington, Rhode Island , and have plans to open a branch in the Olneyville section of Providence and another in Smithfield, Rhode Island in the coming months. We are excited about the deposit, lending, and investment opportunities in these new markets.
Banking in the US is a famously competitive business, competitive because savings accounts and time deposits can compete on only one metric - the interest rate - which makes them akin to a commodity. Rising interest rates have resparked competition in interest rates, which translates into competition in deposits.
...The Washington Trust Company, today announced first quarter 2023 net income of $12.8 million, or $0.74 per diluted share, compared to net income of $16.6 million, or $0.95 per diluted share, for the fourth quarter of 2022...
...Returns on average equity and average assets for the first quarter were 11.27% and 0.77%, respectively, compared to 14.96% and 1.01%, respectively, for the preceding quarter.
We can see from the above graph that quarterly net income has fallen to levels last seen in 2017. The Fed dot plot (previous) showed that long term interest rates should be around 2.5%, but national average interest rates on savings accounts is close to 0.4%:
Hence, there is still plenty of room for competition to squeeze interest rates upwards. Going at this rate, there is still a runway for deposit rates to be pushed up by competition, all the way up to 2%.
The 12-month CD rate is starting to plateau at 1.6%:
This deposit rate squeeze is still ongoing, and so we should expect WASH to be subject to the same headwinds as described in the headline above for a while yet. As deposit rates get pushed higher and higher, profits at WASH should fall lower and lower.
Hence, I believe that WASH is actually priced by the market for a dividend cut in the future. Why? The payout ratio is reaching a multi-year high:
Given our expectations for a few more years of deposit rate competition, we can expect this payout ratio to continue to rise, or at best remain constant.
Hence, I deem WASH a SELL - do not get tempted by the low P/E and P/B ratios, because I believe there will be a protracted risk to the dividend.
For further details see:
Washington Trust: Risks Appear Priced In, But Beware The Dividend Yield