The U.S. banking system has taken a big hit over the past few days with the implosion of Silvergate Capital (SI 2.44%), Signature Bank (SBNY), and Silicon Valley Bank, the main holding of SVB Financial Group (SIVB.Q).
On Sunday night, the Federal Deposit Insurance Corporation (FDIC) stepped in with emergency measures aimed at stemming contagion. Yet despite those moves, Moody's cut its credit outlook on the entire U.S. banking system from "stable" to "negative" on Tuesday.
While these three banks were ill-managed or uniquely vulnerable to rapid interest-rate increases, virtually all bank stocks have declined markedly, and some smaller regional banks with similarities to those mentioned have made huge moves to the downside.
With declines of 50% or more in a short amount of time, are regional banks such as First Republic (FRCB) a huge buying opportunity?
It's possible. Yet while bargain-hunting, make sure to check the following three vital statistics before making any seemingly bargain-priced buys in regional bank stocks. You'll sleep easier knowing you did.
1. What percentage of deposits are insured?
There are two sides to a bank's balance sheet.
- One is assets, including loans, cash and other securities, and operating assets.
- That side is funded by liabilities, usually consisting mostly of deposits, along with some other funding sources, as well as a bit of equity -- usually around 9% to 15% of assets.
Many investors focus on the loan book, but the three banks that got into trouble were each vulnerable to bank runs because their deposits weren't as stable as investors -- and, frankly, the banks' executives -- thought.
Deposits are usually thought of as "sticky," desirable funding, as people don't usually change their checking and savings accounts very often. Yet there are two reasons depositors may flee a bank. One would be if there were similar alternatives that offered much higher interest on deposits. A second would be if depositors feared the bank would go under, and they wouldn't be able to get their money out.
The FDIC insures all deposits up to $250,000, which covers the vast majority of individuals. But a business of any substantial size is likely to require more than $250,000 in the bank at any time -- like SVB's clientele in the venture-backed tech sector. That leaves any bank with a large amount of uninsured commercial deposits open to a bank run, should there be any crisis of confidence on the part of depositors.
You might infer from the Fed's guarantees to the depositors of SVB and Signature Bank that all deposits everywhere will likewise be insured, but as an investor, it's safest not to assume that.
According to the new Bank Term Funding Program (BTFP) unveiled last Sunday, the Fed facility would lend money to any needy institution for one year if those institutions were "pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral... valued at par." Take note of "other qualifying assets." SVB had a lot of government-backed investments in the form of Treasuries and mortgage-backed securities that the Fed probably felt safe guaranteeing; that may not be true of banks with riskier commercial, industrial, or commercial real estate loans on their books.
Meanwhile, on the customer end, risk-averse CFOs may be scrutinizing their banks' loan books much more closely, or just diversifying deposits into larger, more heavily regulated banks out of an abundance of caution.
All of this means that the higher the proportion of uninsured deposits a bank has, the more risks it still has, either from capital flight or higher costs.
So you need to look at what percentage of deposits are uninsured. This figure is usually disclosed in the Report of Condition and Income, or "Call Report," which is filed by banks on the last day of each quarter with the Federal Financial Institutions Examination Council (FFIEC). You can search for your bank's most recent report at the FFIEC website here.
SVB was a huge outlier, with some 93% of deposits uninsured. While your bank probably won't have nearly that proportion of uninsured deposits, the amount in the call report may surprise you. According to Insider Analysis, there were more than $1 trillion in uninsured deposits at U.S. banks at the end of 2022.
While some amount of uninsured deposits is inevitable, that number can vary widely. If you think a regional bank that has sold off 50% or more is a total steal, the uninsured deposit number may give you pause.
How secure are your bank's deposits? Image source: Getty Images.
2. What is the duration risk of loans and securities?
While many bank investors are aware of default risks in a bank's loan portfolio, the Silicon Valley Bank saga has also alerted investors to another risk on the asset side of the balance sheet: duration risk.
Many bank loans, such as mortgages, are made at a fixed rate, and for a long period. The value of that loan may go down over time if interest rates spike higher after the loan is made, as interest rates have done over the past year.
As SVB's tech start-up customers flourished in 2020 and 2021, the bank invested its surge of deposits into long-dated Treasuries and mortgage-backed securities that were "risk-free" in the sense that they were guaranteed by the U.S. government. However, as interest rates spiked, the market value of those securities declined. That became a problem when SVB's customers began struggling -- the bank was forced to sell these assets at a loss to cover fleeing depositors.
The Fed's move last weekend has mitigated this risk, but not eliminated it, as I mentioned in the previous section. Again, we don't know what the Fed's Bank Term Funding Program meant by "other qualifying securities," but it likely didn't mean, say, small business loans.
Banks need to reserve for credit losses when they make loans, but they don't have to mark down their loan values because of higher interest rates, or even government-backed securities, as long as those securities are designated in a "hold to maturity" bucket. Since the value of those loans may be higher than what they could be sold for today, that could mean the current book value of the bank you're looking at may not be as high as it appears, if the bank were to mark all securities to current market value.
Most banks disclose unrealized losses in their hold-to-maturity securities across mortgage-backed securities, municipal bonds, and high-quality short-term corporate credit. Investors should monitor those, but the Fed's recent action means banks can borrow against those securities at par, so it's not as relevant.
But banks typically don't disclose marked-to-market losses from rate increases on their loan portfolios -- just the allowance for credit losses. That means if a bank made, say, a 30-year non-agency mortgage or commercial loan at a low rate in 2020, a potential buyer would pay far less for that loan today than the figure recorded in company filings. The Fed might not lend against those securities if the economy got in more trouble, either -- or at least not at par.
So investors should peruse a bank's annual report, look at the size of its loan book, and perhaps take a haircut to some assets, depending on how long the duration is, the average interest rate, and the nature of the loan. Are there lots of long-duration, low-rate loans on the books? Perhaps you should discount those asset values.
Image source: Getty Images.
3. What is the concentration risk?
A final reason Silicon Valley Bank got in so much trouble was that it was heavily concentrated in one sector: technology. Actually, its concentration was even greater than that, as it was really focused on a subsector of early-stage venture-backed tech companies.
If you're looking at a regional bank, odds are it's more concentrated than a large national bank just by virtue of size and geography. A regional bank in California, even if not specifically geared toward startups, will still feel pressure from rising unemployment in the tech sector. Similarly, a bank concentrated in Texas would probably feel the fallout of a crash in oil prices.
Concentration within a particular sector on both the asset and liability side could spell trouble. If a single industry experiences a severe headwind, that could cause consumers and businesses to draw down deposits, just as the loans and investments made to that same sector go down in value. That's exactly what happened to SVB. And since many of its customers all knew each other within the venture community, that made its deposit base more subject to a large-scale run on the bank as word got around.
While it may be difficult to figure out exactly how concentrated a company is in terms of geography, type of customer, industry, and type of loan, much of this information can be found in the annual report as well. If you're going to take the plunge with a regional bank, concentration risk is also a must-know.
Take the time and make a checklist
To sum up, don't just buy any regional bank that has gone down a lot and looks cheap relative to its past price.
- First, try to figure out the amount of uninsured deposits, and how likely those deposits are to flee.
- Second, look at the company's asset duration and average interest rate on its loan book, estimate how much someone else might pay for those assets today, and make an appropriate cut to book value.
- Finally, be aware of where a regional bank is concentrated, and how likely that industry or geography is to experience a big downturn.
That sounds like a lot of work, and it is; however, the payoff could be big. If you're cognizant of all these risks and still find a beaten-down regional bank stock attractive, you might just have a bargain on your hands.
