Regional Banks Keep Crashing: Where Things Now Stand

On Sunday, it seemed like the banking sector might have made it through the worst of the storm. The government announced a series of new measures to provide stability to the banking system. It did so in conjunction with shutting down another bank, Signature Bank (SBNY), giving the impression that the troubled banks had been dealt with and the government was prepared to provide support for the rest of the sector.

Stock market futures jumped almost two percent on Sunday evening following the news and traders breathed a sigh of relief. That optimism faded by morning however, as futures tumbled overnight. Soon, it became clear that despite the government's efforts, the run on the banking sector hadn't dissipated.

So where does that leave things in the banking sector this week?

Broadening Deposit Insurance

For many years, the Federal Deposit Insurance Corporation (FDIC) has insured deposits up to $250,000 while figures over that amount did not have a guarantee in most cases. This lack of guarantee for large accounts was integral to the collapse of SVB Financial.

That's because SVB had more than 95% of its deposits in uninsured funds due to its focus on providing banking to companies and high net worth individuals that carried large account balances. Once the rumors started about a potential insolvency at SVB, a large portion of the bank's clients pulled their deposits, knowing that the funds weren't insured. This led to the bank being in an untenable position and the government ultimately seizing the bank.

By extending deposit insurance to all deposits, this should greatly reduce the possibility of future such bank runs. Now, clients know that even if their regional bank fails, the FDIC will still be making deposits available to them the next day. This should disarm the fear of a large bank deposit holder losing everything (save $250k) in the event of a sudden run on their own bank.

There's been a discussion around whether the emergency plan constitutes a "bailout" or not. On the one hand, it does protect depositors who were over the $250k limit from harm. That does create a moral hazard of sorts and may cause folks to pile into whatever bank is offering the highest deposit rate today. There could be unintended consequences.

However, the goal of banking regulation has typically been to make sure that deposits are kept safe regardless of what else happens. I don't see a greater deposit guarantee as being an especially bad thing from a market functioning perspective. This wasn't a bailout in the sense that shareholders of the failed banks got any meaningful compensation for their positions.

Sell-Off Continues

In any case, with broader deposit insurance now in place, that should have put out the bank run fire, right? Not so fast. In fact, a number of regional banks have seen their shares implode in Monday trading. Here are some quotes of biggest losers around midday Monday (prices are changing rapidly, this is just a snapshot in time):

• Western Alliance Bancorporation (WAL): -64%
• First Republic Bank (FRC): -61%
• Metropolitan Bank Holding (MCB): -40%
• Customers Bancorp (CUBI): -37%

• KeyCorp (KEY): -28%

I could go on, the list is pretty long, but that gives a sense of the blood on the streets today.

Let's zoom in on one of these in particular. First Republic Bank is now one of the banks at the center of the firestorm, and it is quite the important one. Until recently, First Republic had a market capitalization above $20 billion and it is one of the largest specialty banks in the country, as it has an excellent niche in its wealthy client business.

First Republic shares had fallen around 50% on Friday morning before bouncing and recovering much of their losses. That recovery didn't hold into Monday, however, as shares lost most of their remaining value:

What makes First Republic a bank that traders are so especially worried about?

For one thing, it is headquartered in San Francisco, CA and its business model is aimed at providing high-touch customer service to wealthy clients in industries such as technology. In other words, it has the same sort of client base that was also prevalent at SVB.

For another thing, thanks to its focus on high net worth clients, First Republic has a deposit base tilted toward large accounts. As of recent regulatory filings, 68% of First Republic's deposits were uninsured, meaning they were over the $250k deposit guarantee threshold.

While these funds are now backstopped by the FDIC, it seems likely that all the uncertainty around the weekend likely led folks to begin pulling their deposits before the new emergency measures were announced. And, even with greater deposit insurance in place, many clients are probably going to move money to bigger banks just to have the peace of mind.

As for First Republic, it had substantial losses on its loan book. These were only a fraction of the losses that SVB had before it ceased operations. However, at this point, the market isn't in the mood to give out the benefit of the doubt.

In addition, the Federal Reserve launched a new asset support mechanism to support the banks. However, it only applies to treasury bonds and agency mortgage-backed securities. First Republic owns very few of these types of securities, which means it potentially will get much less help from this facility than many other regional banks.

The Problems Hitting Regional Banks

These are the sorts of discussions folks are having today in trying to analyze the state of regional banks following all the recent events. The risk of contagion should be materially lower given the Fed and FDIC's strong response with enhanced deposit insurance and a new asset-backstop facility.

That said, there are several problems plaguing the regional banks. You have the ones with duration mismatch where they bought far too many long-term bonds that devalued sharply when interest rates soared. You have banks that got caught in the wrong sectors of lending and activity, such as crypto or venture capital. And now there is deposit flight; banks that specialize in high-net-worth clients take a particularly bad hit there. This combination of factors is causing lingering uncertainty over the whole sector despite the tangible steps taken to reassure investors and depositors.

One thing I'd note is that so far, the major bank failures have all been related to cryptocurrency and venture capital. Silvergate Capital was primarily tied to cryptocurrency. SVB Financial was the venture capital bank. And Signature Bank was another bank tied to cryptocurrency, having been in that business since 2018 and having attracted more than $16 billion in digital asset-related client deposits.

While nothing is certain, I'd suspect that the Fed and FDIC will act more strongly the moment that the bank failures start occurring in banks that weren't speculating in these more adventurous parts of the economy. Losing a crypto bank isn't great, but for the mainstream economy, it's not the biggest concern. We'll have a much bigger problem if banks that primarily lend on houses or commercial real estate start failing.

Finally, I'd note that the unrealized losses problem may be self-fixing to an extent. Treasury bonds are the ultimate safe haven asset as the U.S. government, for all its faults, is exceptionally unlikely to default on its debt. In panics, such as now, we see huge rallies in bonds. To that point:

The 20+ Year Treasury Bond ETF (TLT) has rallied 5% recently, jumping from near the lows of the year back toward the highs. This greatly improves the market value of the very securities that have caused many banks so many headaches in the first place. If interest rates stop rising, and indeed start dropping a bit, that would clear up many (though not all) of the problems currently afflicting regional banks.

Regional Banking's Bottom Line

How am I viewing the situation today? I own a number of conservative regional and community bank stocks and will be adding to those this week as situations present themselves.

If you don't have a list of regional banks that you understand and are confident in, I'd strongly consider sticking to the ETFs, namely the S&P Regional Banking ETF (NYSEARCA:KRE) and Nasdaq ABA Community Bank ETF (QABA) which offer a great deal of diversification within them. These ETFs have gotten hammered and offer plenty of upside if things normalize:

In addition to these ETFs, there are some interesting opportunities in preferred shares and LEAP options. Recall that quite a few publicly-traded banks have preferred stocks. The values on many of these have plummeted over the past few days. However, in an event where a bank is acquired for pennies on the dollar, the preferreds should recover their value whereas the common would not. Additionally, in a scenario where a bank diluted its common dramatically to raise capital, the preferred would be spared. Buying preferreds of ailing banks at, say, $8 with upside to $25 could be a better risk/reward than owning the commons directly.

Also, consider looking at LEAP call options for 2024 and even 2025 on some regional banks. I see some interesting situations in this space where options are being priced for 3-4x upside if the underlying regional bank merely trades back to where it was in February, while the downside risk would be capped at the option premium.

The Fed's actions Sunday should materially reduce the risk of a broad contagion in the regional banking sector. And I expect that if the panic continues, the Fed will continue taking more aggressive measures to ensure the banks which serve Main Street America are able to survive. Prices have dropped enough to create some interesting risk/rewards here for investors with a strong stomach.

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