Profitability was the next shoe to drop at banks like PacWest

PacWest Bancorp has a problem — that much is evident from the pummeling its shares have taken in recent days after the U.S. banking crisis was supposed to be over. But it doesn't have the same sort of problems that failed lenders Silicon Valley Bank or First Republic Bank had.

The Beverley Hills-based bank doesn't have a big homogenous group of mostly uninsured depositors. As of Tuesday, 75% of its deposits were fully insured and it has even attracted a little new money since the first wave of panic hit regional banks in mid-March. It also has cash and other liquidity sources amounting to nearly twice the value of its remaining uninsured depositors.

Nor does PacWest have an excessive burden of long-term, fixed-rate assets, which have seen their market values dinged by rising interest rates. Its $2.7 billion of tangible equity at the end of March already has unrealized losses on long-term bonds of $736 million deducted from it. And its mortgages and other real estate loans, which account for 78% of assets, are mostly not fixed-rate lending, which was First Republic's problem. At the end of last year, only 40% of its mortgages and less than 25% of all loans were fixed rate. More than 90% of First Republic's mortgages were fixed rate.

Mortgages like those and long-term Treasurys posed the same threat of heavy losses among the banks that have failed so far. Of course, any bank that had to suddenly sell a lot of assets to repay depositors would likely not be paid what its accounts say they are worth. But you only have to sell if your depositors are deserting you: PacWest's deposits are stable and mostly insured, so what gives? Its stock price was down another 40% Thursday afternoon and has lost nearly 90% of its value since March 8.

This banking crisis looks like it is morphing into a more subtle but potentially equally deadly phase. The problem is all about profitability and whether banks can adapt. In a way, PacWest's issues are more like those faced by Credit Suisse of Switzerland than SVB. It is at risk of falling into a vicious spiral of weaker returns undercutting the share price and spooking depositors.

Since mid-March smaller U.S. banks have had to compete ever harder for deposit funding because of the safe-haven attractions of the biggest lenders plus the higher returns already available from money market funds. The result is a sharp rise in funding costs for lenders like PacWest.

PacWest has become more reliant on higher cost consumer and brokered time deposits, which lifted its total deposit cost to 1.98% in the first quarter of 2023 from 1.37% in the previous three months. It has also borrowed more from costlier sources like the Federal Home Loan Banks, the Federal Reserve's Bank Term Funding Program and capital markets. Taken together these changes helped to slash its net interest margin to 2.89% in the first quarter from a fairly consistent 3.4% last year. Analysts expect it to fall further to about 2.5% on average for this year, according to data complied by Bloomberg.

The squeeze on lending margins hurts revenue and profitability. The past two quarters have produced its lowest pretax profits since the third quarter of 2020. Its next two quarters are forecast to be even worse.

Weaker profits degrade the value of its shares. But the current fear of wider instability has made these problems more dangerous by creating a feedback loop: Falling share prices make depositors more skittish, funding costs rise further, profitability worsens and around it goes again.

Investors, or "the market," are sniffing out the weak links and putting pressure on them to see if they break. It might not even matter whether the deposits of smaller banks are mostly insured or not when money market funds are already such an attractive alternative. PacWest has cut staff and is selling assets to tackle the profitability issue, but for smaller, less-diversified banks the costs of making big changes can be outsize.

For lenders with less customer diversification or room to change their business, it might not take much to kick start this kind of vicious spiral. And once it gets going, it is hard to stop.