On May 2, PacWest stock fell 28%. Is the cascade of bank failures — bracketed by the March 10 collapse of Silicon Valley Bank and JPMorgan’s May 1 takeover of First Republic — over?
After the Federal Reserve Bank raised rates another 0.25 percentage points on May 3, I do not think so.
Higher interest rates intensify the spread of the latest bank failure virus that drives deposits out of vulnerable banks, tanks their stock prices, and ultimately prompts an FDIC-enabled rescue.
Here are three ways higher interest rates boost the risk of more bank failures:
- They prompt more people to move money from low-yielding bank deposits into government-securities backed money market funds.
- They slash the value of banks’ long-term mortgages and bond holdings which could make it difficult for them to come up with the cash needed to redeem a wave of deposit withdrawals.
- They trigger further declines in the stock prices of banks that have already lost significant value since SVB’s collapse.
Look at recent developments at PacWest — 18.24% of its float is sold short, according to the Wall Street Journal. Additionally, interviews with financial industry experts suggest JPMorgan CEO Jamie Dimon’s comment that the bank’s First Republic rescue marked the end of the recent market turbulence will not inoculate the banking system from further consolidation.
Investors should consider whether PacWest — which said it added deposits in April — could withstand further turbulence.
(I have no financial interest in the securities mentioned in this post).
Fed To Raise Interest Rates
Many powerful forces are dampening the economy — but the Fed still raised interest rates by 0.25 percentage points to a range between 5% and 5.25%.
The current banking crisis is putting the brakes on the economy. According to the Washington Post, “tremors in the financial system” due to the failure of SVB, First Republic and others are making banks less likely to loan money.
In addition, economic growth and the job market slowed in the first quarter. GDP growth increased a lower than expected 1% and job openings fell more than expected in March as “layoffs and discharges” jumped, the Post noted.
Nevertheless, inflation remains way above the Fed’s 2% target. Consumer prices rose 5% in March, according to the Post, while the Labor Department reported that private-sector wages and salaries rose 5.1% in March.
Fed Chair Jerome Powell’s statement about possible future rate increases was ambiguous. CNBC wrote the language in the Fed’s May 3 statement was “at least a tenuous nod that while tight policy could remain in effect, the path ahead is less clear for actual interest rate hikes as policymakers assess incoming data and financial conditions.”
Can PacWest Survive The Bank Failure Pattern?
While higher interest rates contribute to bank failures, they are not the only cause.
How 2023’s bank failure pattern works
Bank failures this spring have followed a common path:
- Bank executives failed to anticipate rising rates. Before the Fed started raising rates in March 2022, some banks took in deposits from venture-backed startups — many above the $250,000 FDIC insured limit — and lent out the money in fixed-rate mortgages or bought long-term bonds.
- When rates rose, bankers reacted too slowly to warnings. As the Fed raised interest rates, regulators and ratings agencies warned banks their financial health was endangered because the higher rates cut into the value of those mortgages and bonds.
- Their abrupt reactions triggered social-media fueled deposit runs. SVB responded to a February credit-downgrade warning by selling underwater bonds — taking a $1.8 billion loss that spooked venture capitalists and their startups to withdraw their money en masse with a push from tweets like “YOU SHOULD BE ABSOLUTELY TERRIFIED RIGHT NOW” from angel investor Jason Calcanis.
- Stock price plunges signaled the next bank to fall. SVB’s stock price plunged, and trading was halted as the FDIC was unable to find a private rescuer to save it. A similar dynamic took place with First Republic — although it was drawn out longer before JPMorgan stepped in. These failures triggered drops in shares of other regional banks.
Can PacWest survive the bank failure pattern?
Beverly Hills, Calif.-based PacWest — a provider of business banking and treasury management services to small, middle-market and venture-backed businesses — has suffered a 74% drop in its stock price since SVB’s collapse on March 10.
Since then, PacWest stock has moved due to three significant events:
A post-SVB deposit drop
PacWest stock fell 17% on March 20 after it reported a 20% drop in deposits to $27.1 billion between the end of 2022 and March 20 of this year — largely from venture banking clients that accounted for 24% of its deposits that day, according to a press release.
PacWest raised nearly $18 billion in financing in the wake of those deposit withdrawals. This included borrowing $3.7 billion from the Federal Home Loan Bank System, $10.5 billion from the Fed’s discount window, $2.1 billion from the Bank Term Funding Program as of March 20, and $1.4 billion “from a financing facility from Apollo Global Management
APO
A solid first quarter earnings report
PacWest’s first quarter earnings report caused investors to cheer — sending its stock up 14% on April 25. According to MarketWatch, PacWest reported deposits increased $1.1 billion between March 20 and March 31 and the bank added about $700 million more in deposits as of April 24.
Meanwhile PacWest’s adjusted earnings beat expectations while its net interest income fell short. Specifically, PacWest’s adjusted earnings per share of 66 cents were a penny above the FactSet consensus, while its net interest income — revenue from loans less deposit and other funding costs — totaled $279.3 million, about $12 million below the consensus, MarketWatch reported.
JPMorgan’s First Republic takeover
PacWest shares lost 28% of their value on May 2, the day after JPMorgan’s First Republic takeover.
While CNBC could not offer an explanation for PacWest’s plunge, one analyst suggested that the stock price is the market’s way of signaling which bank is the next one to require a government-assisted rescue.
Chris Whalen, chair of Whalen Global Advisors, told the Financial Times, “They are going from the weakest bank to the weakest bank. And it’s not just the short sellers but it’s the customers as well asking if their deposits are safe. The market is focusing on the weakest links and looking for banks that are vulnerable.”
I am thinking that Whalen’s comment is a more measured version of what Calcanis tweeted about SVB in March.
What Experts Think Could Happen Next
Experts have different views of what will happen next — none of which are bullish on the banking system or the economy.
Michael Milken sees more damage due to bad matching of bank borrowing and loan terms; Charlie Munger sees risk in banks that lend to office landlords; and a former Goldman Sachs managing director, Alla Gil, sees a need for comprehensive risk analysis and mitigation.
Bad asset liability management
A former Drexel Burnham junk bond king, Milken chastised bankers for violating Finance 101. As CNBC reported, Milken attributes the current banking industry woes to its decision to finance long-term loans and investments with short-term borrowing and flighty deposits.
Such a mismatch between when long-term loans are due to be repaid and short-term borrowing must be refreshed puts a bank in big trouble when interest rates are rising. Specifically, banks will have to pay more to borrow money while the interest rate they earn on loans and investments remains low.
The result could be more fleeing depositors who see no reason to stick around for a feared FDIC takeover. Investors are likely to continue to punish other lenders with a “high percentage of uninsured deposits and potential severe bond losses on their balance sheet,” noted CNBC.
Meanwhile, Milken sees loans moving from banks to pension funds which have long-term liabilities that match the long-term loans and bonds. As Milken said, “People are so focused on credit risk but one of the great risks is interest rate risk.”
Commercial real estate risk
Banks with exposure to commercial real estate could also be in trouble. Investcorp co-chief Rishi Kapoor told the Milken Institute Global Conference financial conditions will be constrained because of the bank failures.
Moreover, Munger highlighted the dangers of commercial real estate exposure due to higher interest rates and lower demand for offices due to the continued prevalence of working from home, Financial Times noted.
Comprehensive risk assessment and mitigation
Alla Gil — who currently is CEO of risk technology company Straterix and also a former managing director and global head of strategic advisory at Goldman Sachs — said financial executives must look systematically at their risks and protect against them.
An independent analysis of these risks is particularly important for financial institutions that are most vulnerable to rising interest rates and asset-liability mismatches.
As Gil said in a May 1 interview, financial executives must use “a top-down approach to analyze the full range of economic scenarios and assess the potential ripple effects on their portfolios. Investors should review their liquidity positions, hedging strategies, and counterparty exposures and develop a proactive risk mitigation strategy.”
Gil expects further banking industry consolidation, tighter credit, and a rise in loan defaults. As she said, other banks have an SVB-like approach to “funding, investing, asset-liability and general balance sheet management. If banks lack the capital to lend, the cost of funding goes up, companies pull out their deposits and eventually start defaulting on their loans.”
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