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PacWest Bancorp (NASDAQ:PACW) saw new upside share price momentum this week after the troubled lender reported that it was selling a construction loan portfolio for $2.6B to real estate firm Kennedy-Wilson. The transaction comes shortly after the community bank tried to assure investors that deposits have been flowing back to PacWest Bancorp and said that it was pursuing strategic asset sales to improve its capital ratios and liquidity profile. The announcement caused PacWest Bancorp’s share price to soar on Tuesday and Wednesday. Since the deal is good news for the bank and investor sentiment has also slightly improved since I last wrote about the lender, I am upgrading my investment rating on PacWest’s shares from sell to hold!
PacWest Bancorp faces considerable risks in the short term
I want to make clear from the outset that PacWest Bancorp remains a very high risk investment in the community banking sector. Investors may very well see a complete loss of capital if the lender were to see deposit outflows or if the market forced the community bank to flee into the arms of a top tier bank.
After the failure of First Republic Bank at the beginning of the month, PacWest Bancorp reiterated that it hasn’t seen a major outflow of deposits. As I mentioned in my last work on PacWest Bancorp — PacWest: The Risk Matrix Just Changed — the community bank has seen a stabilization of its deposit base after the end of the first-quarter.
What was also especially encouraging in PacWest Bancorp’s liquidity update from May 4, 2023 was that risks in the bank’s deposit base have further decreased after the end of the quarter: the community bank posted an insured deposit ratio of 75% as of May 2, 2023, as opposed to 71% at the end of Q1’23. However, the bank may lose deposits if the situation in the community banking market goes from worse to worst and more banks fail. I don’t believe this is a highly probable event, but investors buying PACW must consider the possibility to lose their entire investment.
Strategic loan sale to Kennedy-Wilson set to improve liquidity and capital ratios
On Monday, PacWest Bancorp said in a regulatory disclosure (8K Source) that it sold a $2.6B construction loan portfolio to real estate investment firm Kennedy-Wilson and by doing so the lender followed through with its announcement made earlier in which it said that it is exploring strategic asset sales in order to improve its liquidity profile. The construction loan portfolio included 74 real estate loans and the transaction implied a discount of approximately $200M. PacWest Bancorp also agreed to sell to the real estate firm an additional 6 real estate construction loans with an aggregate principal balance of $363M.
Improving liquidity and boosting capital ratios is now a key concern for PacWest Corporation and other community banks that have been hit by deposit outflows in March. PacWest Bancorp has previously said that it plans to achieve a 10.0% CET1 capital ratio by selling its lender finance loan portfolio. The CET1 ratio measures a bank’s capital strength and indicates its resilience in times of economic distress. PacWest Bancorp’s CET1 capital ratio at the end of the first-quarter was 9.2% so the loan portfolio sale is going to boost both the bank’s capital base as well as its liquidity.
Source: PacWest Bancorp
Common stock dividend cut
PacWest Bancorp announced (effectively) the suspension of common stock dividends in May while reaffirming its commitment to paying dividends on its outstanding preferred stock. The common stock dividend has been cut to a symbolic $0.01 per-share quarterly which was done in order to help the community bank save cash.
PacWest Bancorp’s valuation
PacWest Bancorp is still the community bank with the largest discount to book value and I don’t expect this to change in the near term. PacWest Bancorp is currently selling at a price-to-book ratio of 0.4X while other community banks also continue to sell at exaggerated discounts to book value. I have made aggressive investments in the community banking sector in the last two months (ranked based on size): U.S. Bancorp (USB), Western Alliance Bancorporation (WAL), Comerica (CMA), PacWest Bancorporation, KeyCorp (KEY) and Fifth Third Bancorp (FITB).
Biggest risk for PacWest Bancorp
The biggest risk for the community lender is that operating conditions in the financial system deteriorate and that investors pull their funds from the bank. While the odds of a bank collapse have decreased after PacWest Bancorp successfully completed its construction loan sale to Kennedy-Wilson, I believe that there is still a risk that the financial crisis could get worse.
Final thoughts
PacWest Bancorp followed through with its announcement that it will sell non-core assets in order to improve its liquidity profile and balance sheet. The company’s construction loan sale to Kennedy-Wilson is expected to raise PacWest Bancorp’s CET1 capital ratio from 9.2% at the end of the first-quarter to approximately 10%… which could help take pressure off of the bank’s valuation. I believe it was very good news for shareholders that the troubled lender could sell its lender finance loan portfolio at a time of crisis… which is the main reason why I am upgrading my investment rating from sell to hold.
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