Research — 5 Jul, 2023
Bank investors can find diamonds in the rough amid funding pressures
"Street Talk" is a podcast hosted by S&P Global Market Intelligence that takes a deep dive into issues facing financial institutions and the investment community.
The liquidity crunch that erupted in March made deposits more precious, but performance has diverged between institutions of different sizes and regions, according to Josh Siegel, chairman and CEO of StoneCastle Partners LLC
In the latest Street Talk podcast, Siegel discussed the liquidity pressures facing the industry and how they are far more acute for regional banks than the nation's largest and smallest banks; the strategies institutions are employing to compete for deposits; potential regulatory changes; the outlook for capital raising activity and the risk posed by commercial real estate.
Deposits fell 2.5% across the banking industry in the first quarter, building on the roughly 2% in outflows in 2022. However, large regional banks with assets between $50 billion and $250 billion saw their deposits fall nearly 10% in the first quarter, with stress at three failed institutions — First Republic Bank, Silicon Valley Bank and Signature Bank — driving roughly 75% of the decline.
The majority of the largest banks, meanwhile, experienced modest declines in deposits in the first quarter and several of those institutions reported inflows from troubled institutions on their respective earnings calls. Siegel said Wells Fargo & Co. recently told him that the institution had turned off its broker/dealer sweep funding because the institution was flush with deposits.
"Now, that's not the same across the board, but it's not a level field," Siegel said in the episode. "I would say the preponderance are more challenged than they were, but there are definitely banks out there that are flooded. And it tends to obviously be larger banks, but not completely. There still are smaller banks that are flush."
Siegel had expected many smaller banks to be looking to protect their commercial depositors and utilize deposit-spreading services like those offered by IntraFi Network LLC. However, he said most smaller banks' CEOs have suggested that only a few of their customers have sought added deposit insurance protection.
"It's obviously more challenging than it was, but it's not a desperate situation," Siegel said.
More challenging operating conditions are reflected in bank valuations, which have fallen 30% this year, with the bulk of the decline coming since March. Siegel said the bank group appears "generally cheap." He said a small group of banks got into trouble by betting on interest rates as they built bond portfolios further out the yield curve when rates were near historical lows. As rates increased substantially, those bond portfolios moved deeply underwater, hitting tangible common equity, while setting the stage for net interest margin pressure.
Siegel said there are 204 banks that fit that bill and noted that those institutions have large securities books with an average life of 13 years. Those banks face challenges now, but he noted that the rest of the industry — roughly 4,000 institutions — is not in the same situation.
He said the average investor cannot tell the difference between good and bad institutions but said bank-specific investors can find a lot of value. To illustrate the point, Siegel referenced the old adage of a young apprentice and a jeweler. Every day, the apprentice looks at stones for the jeweler and becomes frustrated thinking they have not learned anything only to realize that, after some time, experience has allowed them to distinguish between a normal stone and a diamond.
"We call it holding the diamonds. When you're around it long enough, you tend to see the patterns of good strategy and management and bad," Siegel said, adding that there are "a lot of oversold platforms because people can't tell the difference."
The veteran investor had a similar take on banks' exposure to commercial real estate, which has drawn concern from much of the investment community. He acknowledged that large office properties will face considerable challenges this year, but said that there are multiple, other categories within commercial real estate and noted that the asset class will be market specific.
For instance, Siegel said fast-growing markets like Charlotte, NC, or Nashville, Tenn., are unlikely to have as many problems given the tailwind offered by growth. He also said most community banks tend to have much greater percentages of owner-occupied real estate in their loan portfolios, which is just a business loan secured by real estate.
"I don't think that this is going to be any kind of a repeat of '08. I think this is the normal credit cycle that banks are meant to absorb. Earnings will probably be punished for the next six, 12, 18 months. And then it goes back to the cycle," Siegel said.
This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.