Regional Banks Crash: Why The Sector Is Plunging

Silvergate, SVB, and First Republic among regional banks taking large hits. Here's why traders are selling the sector and what it means more broadly.

The regional banks are having a dreadful day, with the sector ETF down more than 7% as of this writing. Indeed, the KRE ETF has thudded to new 52-week lows:

This is a massive decline in what’s usually a sleepy corner of the market. I don’t recall seeing these sorts of moves in smaller banks since the 2008 financial crisis. Not surprisingly, with the sector ETF down more than 10% in a week, virtually all regional banks, regardless of their specific business models or outlooks, are getting sold off in sympathy.

As such, it’s worth examining why the market is panicking, how much of the concerns are warranted, and what sorts of opportunities that it may create for buyers today.

What Happened? A Run On The Bank

The most obvious source of the recent unease with regional banks has come due to the spectacular declines of a few crypto-currency related banks.

Former Cathie Wood favorite, Silvergate, has plunged to just $3 per share following news that the bank is liquidating following its recent large losses. Shares are down another 25% today, 80% year-to-date, and 97% year-over-year:

Silvergate had been in business since the 1980s. However, after it pivoted to cryptocurrency, it quickly ran into trouble.

However, the cause of its death is a little more complicated than might first be apparent.

Silvergate took in billions of dollars in cryptocurrency deposits. It then acquired long-term assets with these deposits. Those assets declined sharply in value thanks to the rise in interest rates, which causes the value of previously issued fixed income assets to fall. The bond market has witnessed an historic fall since 2021, and this ultimately was Silvergate’s undoing.

Here’s how the fall in bond prices connected to crypto. As the Bitcoin market entered a deep freeze last year, tons of crypto-related deposits exited Silvergate. The bank replaced these deposits with money from the Federal Home Loan Bank “FHLB”. The FHLB serves as a backstop for providing financing to smaller regional and community banks. However, it tends to charge much higher interest rates and is not an ideal source of long-term bank funding.

And, in this case, once Silvergate’s solvency came into question, the FHLB demanded its money back. This, in effect, made it impossible for Silvergate to continue operations, as there was no way to plug a multi-billion-dollar hole in the balance sheet that quickly. That was doubly true since Silvergate was under investigation from various U.S. regulatory bodies including the SEC, making it far more difficult to raise new funding.

So that’s Silvergate. By itself, however, Silvergate is not a big deal. It was a small bank engaged in some audacious business ventures that didn’t ultimately pan out. And now it is shutting down.

But why are other regional banks now tanking?

Asset Issues Popping Up At Other Banks

The biggest headline Thursday was California-based Silicon Valley Bank or “SVB Financial” raising funds. This caught the market totally by surprise, to put it mildly, and SIVB shares have plunged 47% today:

The stock is now down more than 75% from its 2021 highs. SVB Financial is engaged in banking with a lot of smaller tech, biotech and other such venture companies. This made for great business during the venture bull market but has been much less fruitful since the tech bubble popped in 2021.

Additionally, SVB took aggressive bets with its balance sheet. One person on Twitter (unfortunately I can’t remember who to credit properly) described SVB an undercover hedge fund betting on interest rates while masquerading as a bank.

And those bets came up empty amid the current interest rate environment. SVB announced today that it had sold a massive chunk of its securities portfolio at depressed prices, locking in a $1.4 billion after-tax loss.

SVB Financial had a $15 billion market cap prior to today, however it will be far less than that after this recent debacle. In addition, SVB announced it will be issuing $1.25 billion of common stock and $500 million of preferred shares to fill the hole in its balance sheet from taking large losses on its securities portfolio. That dilution is casting a grim light over the stock’s outlook.

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SVB had long been a popular holding with hedge funds and other sophisticated investors. Shares had run up from $50 in 2011 to $800 in 2021 after all. The bank’s mix of venture capital-driven deposits and highly-levered securities book looked tremendous in favorable market conditions. But it ultimately came at a high price.

After watching SVB shares lose half their value in a single day, traders understandably asked “What’s next?” If the contagion isn’t over, what other banks might be in the spotlight.

Specifically, on Thursday, we also saw big declines in the following financial stocks:

• Pacwest Bancorp (PACW): -21%

• First Republic (FRC): -16%

• Western Alliance Bancorp (WAB): -13%

• Charles Schwab (SCHW): -11%

A couple of these make inherent sense. Pacwest has a lot of exposure to similar industries and clients as SVB so traders are selling first and asking questions later. Western Alliance Bancorp also fits with the run on west coast banks theme.

However, the other two names are arguably more interesting.

First Republic was arguably the single most popular regional bank with hedge funds and institutional investors. The bank aims its business at wealthy clientele, offering them a high-touch service. This, in turn, should attract stable deposits while offering strong opportunities for fee generation.

First Republic was a classic compounder, at least until last year:

Shares are now back to 2017 levels, however, undoing a great deal of the gains that were made along the way.

I never understood the valuation story at First Republic; shares were trading above 25x earnings at one point, which is simply far too high compared to where the rest of the industry was trading. I’m not usually a person opposed to paying a higher multiple for a better-quality company, but in a world where America’s most efficient well-run bank — Hingham Institution For Savings — was going for 12x earnings, I struggled to understand paying more than 20x for First Republic.

Even now, First Republic is at 13x earnings and 1.4x book value, which is a much more reasonable level given its impressive track record, but it’s hardly a fire sale price either.

Why would First Republic be down 15%+ today whereas many other peer banks are down 5-8%?

That’s probably due to First Republic being headquartered in San Francisco and having more exposure to the same factors that caused SVB and others to blow up. That said, First Republic should be in much better shape. Its unique business model leads to structural advantages (such as a customer churn rate 75% lower than peers) which should help it maintain its deposit base in a weaker economy. That is directly opposite to the cryptocurrency banks, which blew up since when their deposits left they couldn’t plug the hole from falling asset prices.

Charles Schwab is another interesting big loser. It appears investors are throwing in the towel on this whole sort of levered bet on rates sort of trade. Reportedly, JP Morgan was selling a huge block of SCHW stock Thursday morning and that led to a waterfall-style selloff throughout the day.

The thesis on Schwab was supposed to be that higher interest rates would lead to far higher profitability thanks to having access to low-cost customer brokerage deposits. That thesis is valid enough, on paper, but there was a lot of “hot money” attracted to the Schwab trade in particular that might not have been that familiar with the underlying numbers and mechanics there. Seeing something like the SVB fiasco makes folks dial back their exposure to any sort of levered rates trade until the market properly digests winners and losers in the new environment.

What This Means For Regional Banks More Broadly

It’s worth reminding that in aggregate, higher interest rates are good for regional banks. There is a reason people bought bank stocks on the prospect of rate increases after all. The face that some banks screwed up their loan books or had too thin a deposit base for current conditions doesn’t invalidate the whole rising interest rate theme.

However, there is a great deal of variability in-between different regional banks. Some have a loan book and deposit base well-crafted for sharply higher interest rates, while others see little benefit and may even see earnings decline in the face of higher interest rates. Every bank has to pay for deposits while earning on its corresponding assets. If it gets either side of the equation too wrong, higher interest rates won’t necessarily improve the situation.

What went wrong for the crypto banks in particular was that they made leveraged aggressive bets on long-term securities while funding it with deposits backed by Bitcoin and other speculative assets. Once the deposits left, the banks had to realize losses selling down their security portfolios at whatever price the market would pay today rather than being able to hold until interest rates normalize.

Most banks won’t face this situation because they have steady deposit bases. Banks can simply hold securities to maturity and wait to get paid the interest they are owned on their assets, regardless of near-term market pricing. And, for many banks, they prefer to make their own mortgages and loan products, rather than buying securities from others. Holding a mortgage on your own balance sheet doesn’t expose a bank to the same optical risk as owning securities that are marked-to-market every day based on fluctuations in interest rates.

A well-run bank is constantly managing its deposit and asset base and making internal adjustments as necessary. They are designed knowing that interest rates will rise and fall and the bank manages around that fact.

Like with so many other things in the late 2010s, however, some banks like Silvergate and SVB took too much of a good thing and turned it into a bad one. If getting cheap deposits and levering up on higher-yielding securities was good for profitability, why not repeat that process up to the maximum that could possibly be allowed. As we’ve seen this week, however, there was no free lunch to be had.

Fortunately, most banks didn’t bet the farm in this way. As Oppenheimer’s analyst put it in covering SVB Financial’s problems:

“We remain on the sidelines with regard to SIVB and want to stress that we see it as an outlier in the industry. Other banks have underwater bond portfolios as well, but they generally have lots of retail deposits, which are much less rate-sensitive than SIVB's deposits."

I expect a lot of investors are making panic sales on regional banks today given this seemingly new risk. Since 2008, all we’ve heard about is housing bubble this and CDS that. That was people’s stereotype of risk in the banking industry. Now, we’re seeing a different kind of risk — duration mismatch on the balance sheet. This was a normal risk to banks in the 1970s and 1980s, but one that a lot of people had forgotten about in the era of perpetually low interest rates.

This won’t be a big deal for most regional banks, and the sector will get back on its feet soon enough. Earnings on the whole have been reasonable for the sector, certainly nothing that would justify 52-week-lows on the ETF. However, until we see the last dominos fall from the crypto and Silicon Valley related banks, we may see more jitters in the regional and community bank space more broadly. That should lead to some great buying opportunities, which I will discuss more in future posts.