PacWest: The Crisis of Trust in Banks Claims Another Victim

Just this past Monday, as JP Morgan (JPM) bought the late First Republic Bank’s (FRC) business after a regulatory takeover, the financial giant’s boss Jamie Dimon declared that “The U.S. banking crisis is over.” On Wednesday, another large regional bank said it’s “exploring strategic options” – which can be translated as, “Please help, we are in a huge amount of trouble.” Gentle reminder: FRC was also exploring “strategic options” just before it was seized by the regulators. Thus, another chapter in the U.S. regional bank crisis has begun.

Dimon To the Markets: It’s Fine, Everything Is Fine

We are all humans, and humans make mistakes – even if they are the CEO of the largest bank in the U.S. and one of the largest in the world. But I believe that Dimon was just trying to talk some sense into the markets.

Besides being hailed as the hero and the savior of the country’s financial system, buying failed banks is a very profitable business. However, a serious financial crisis would eventually harm everyone, including JPM. Since financial crises stem from a crash in confidence, it’s clear that Dimon was trying to restore trust in the U.S. financial system, wielding his immense authority and the fact that the markets seem to trust him more than Jerome Powell.

Well, sometimes even the best of them don’t succeed. The KBW Nasdaq Bank Index tumbled after the FOMC’s rate announcement, falling to levels last seen in October 2020. Taking into account that the Fed’s decision was an exact match to market expectations, this suggests a total lack of confidence in regional banks. 

PacWest: Another One Bites the Dust

On Tuesday and Wednesday, while markets awaited the Fed’s announcement on Wednesday in a generally optimistic mood, regional banking stocks tanked in anticipation of another rate hike. The Fed’s “fast and furious” tightening was what got them in trouble in the first place. Thus, an expected pause didn’t help the sentiment as banking troubles won’t be mended by anything less than a significant rate cut – which, Powell said, is not to be hoped for anytime soon (barring an all-out financial crisis, of course).

The biggest losses were made after-hours, as PacWest Bancorp (PACW) sunk 56% following the news that it was seeking ways to climb out of the hole, including asset sales. Other regional banks also tanked: notably, Western Alliance (WAL) shed as much as 30% after the close; Comerica (CMA), Zions Bancorporation (ZION) tumbled, and even their bigger counterparts such as Truist Financial (TFC), and US Bancorp (USB) dropped. Western Alliance can be marked as a probable next target of the market’s fury, but let’s focus on the immediate casualty.

Since the SVB collapse, PacWest’s stock has been the most volatile in the regional banking index after the FRC’s shares. Naturally, traders focused on it after First Republic was no more; the bank’s stock has been heavily shorted. PACW’s market cap now is a third of what it was at the beginning of this year. PacWest has one of the highest concentrations of commercial real estate loans among the regional banks; the conviction among various pundits has been that CRE (commercial real estate) loans will be the culprit of the next round of trouble for the lenders.   

It seems that PACW’s proactive efforts to secure capital and reassurances that its cash exceeded non-insured deposits failed to comfort investors. PACW shares declined about 90% since the onslaught of the banking crisis on March 8^th. That’s what happens when there’s a lack of trust – the glue that keeps the banking system together.   

More Assets in Failure Than in 2008

In 2008, at the height of the GFC (Global Financial Crisis), there were 26 bank failures in the U.S. This year, there were only three (PACW is still alive, albeit barely) – but the total assets of the 2023 failures are bigger than those of the 2008 casualties. Although the crash of Washington Mutual in 2008 remains the biggest in history (so far), FRC, SVB, and Signature collapses are now the second, the third, and the fourth biggest ever by assets. At this point, no one can be certain that we’ve seen the last of the current banking crisis.

The domino effect that started with the SVB collapse and was quickly followed by Signature Bank, First Republic, and now PACW, is not that easy to stop. Even if the current main problem, the breadth of the uninsured deposits on the banks’ books, is addressed, i.e., the regulators extend blanket insurance to all, there are other things to worry about.

The proportion of U.S. residential real estate lending done by small- to mid-sized banks (with assets below $250 billion) is around 60%; they supply above 80% of commercial property loans. The U.S. real estate market in general is slowly slumping in response to higher rates and a weakening economy, but CRE could prove to be the biggest problem for the banks in the months ahead. Some commercial property pockets, such as malls, have been wilting since the turn of the century. CRE prices have generally never recovered from Covid-19 restrictions, taken down by the work-from-anywhere trend; now they are sinking under the Fed’s heavy hand.

Commercial Real Estate, Business Lending, and All That Jazz

Charlie Munger, the Vice Chairman of Berkshire Hathaway (BRK.B) and Warren Buffet’s lifelong associate, is convinced that CRE will be the next leg of the crisis – although, he says, the situation now is not nearly as bad as it was in 2008. He should know, as Buffet’s firm was the one who saved Goldman Sachs (GS) in 2008 and helped Bank of America (BAC) get out of trouble in 2011; both investments were immensely profitable for Berkshire, and they also helped the U.S. avoid a complete demise of its banking system by upholding the systemically important lenders.

Jamie Dimon’s JP Morgan is now in the same role as Berkshire was during the GFC and its aftermath. Although Dimon certainly has a vested interest in banking stability, he, too, acknowledges the problem with CRE lending. According to Dimon, investors are still exposed to the risks brought on by interest rates increasing to their highest since 2007 and their effects on various assets, including real estate.

As the sentiment in regional and smaller banks continues to fall, deposits leave them in droves. This worsens the situation for many lenders, who, in response, have to dial back on credit. Credit conditions in the U.S. are already at their tightest level since the COVID-19 pandemic; they are expected to tighten further as long as the banks are insecure. Tighter lending has historically brought on a higher percentage of corporate defaults, which then come back to hitting the banks’ books.

Given that regional and smaller banks account for nearly half of the business lending in the U.S., we can probably point at lending to companies as the next chip to fall after commercial real estate. With so many current and potential pain points, investors are not advised to try and chase the dip in regional banks’ valuations, even if Jamie Dimon promises to buy them all.

Meanwhile, may the Force be with us all.