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These regional banks could be in for consolidation as failure risks rise again

Published 03/14/2024, 09:58 AM
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Investing.com — Just as the market was beginning to think bank failures were a thing of the past, a full year after the Silicon Valley Bank collapse, issues with New York Community Bancorp (NYSE:NYCB) last week raised the alarm that a new slew of problems for the smaller players could be percolating underneath the surface.

As persistently high rates keep pressuring regional banks, and as the Fed prepares to cease the Bank Term Funding Program, which provided a much-needed lifeline for the industry last year, experts are increasingly thinking we could be in for an uptick in consolidations.

In fact, Fed Chair Jerome Powell himself said last week that “there will be bank failures,” adding that, “it’s more smaller and medium-sized banks that have these issues.”

The issues referred to by the Fed's chairman are the heightened risks associated to commercial real estate (CRE) losses. As REITs such as Alexandria Real Estate Equities (NYSE:ARE), Boston Properties (NYSE:BXP), Kilroy Realty (NYSE:KRC), and Vornado Realty Trust (NYSE:VNO), which compose an important part of many regional banks’ asset and loan portfolios, have trended lower over the last few months, pressure on regional banks' balance sheets has been on the rise.

“The risk is most pronounced with small/regional banks since they hold ~70% of CRE loans across the banking system,” explains Andrei Belov, Chief Investment Officer at Shade Tree Advisor. “There are over $1 trillion of CRE loans projected to mature in the next couple of years,” he adds.

Vineer Bhansali, Founder and CIO of Long Tail Alpha and former head of Quantitative Portfolios at PIMCO, believes that the current setup will lead to consolidation within the industry. “Due to an inverted yield curve, long duration assets, and high cost of deposits, the smaller banks are still in trouble. I do believe regionals with lots of CRE exposure and asset-liability mismatch will need to consolidate,” Dr. Bhansali told Investing.com.

Are Regional Banks on the Verge of Another Disastrous Moment?

While experts agree that we are likely to see more failures within the regional banking industry this year, the consensus is that a new GFC-reminiscent moment remains unlikely.

“The vast majority of the banks experiencing trouble have a unique risk profile relative to peers. This is a combination of unusual lending concentration, cryptocurrency, and venture funds, as well as, in some cases, concentration in commercial deposits and other less stable funding sources,” Jason Langan, Partner of Merger & Acquisition Transaction Services at Deloitte and National M&A Industry leader for Financial Services, told Investing.com.

Mark Rodgers, CEO at Board Prospects, also agrees that risks are not as high as they were last year as they are limited to banks with a particular type of portfolio composition: “Similar to NYCB, I believe that regional banks with significant exposure in commercial real estate are particularly vulnerable. Higher interest rates coupled with a larger degree of uninsured deposits at certain banks is a major problem,” he says.

David Abramson, Chief U.S. Strategist and Director of Research at Alpine Macro, also sees better management in US regional banks this time around. “Regional banks have been cautious since the 2008 crisis. Their big troubles have been mark-to-market on credit risk-free government bonds,” he explains.

Andrei Belov ponders that while more banking failures are on the cards, further consolidation will likely be “an ‘orderly’ process and certainly not catastrophic to the financial system ala GFC.” “There’s a lot of dry powder sitting on the sidelines waiting to take advantage of these types of opportunities,” he adds.

Is It All About the Fed?

Another reason why we could be in for an ‘orderly’ consolidation trend - as opposed to what we saw last year - is that the Fed is paying very close attention to these issues so that they don’t begin to snowball again.

“We are in dialogue with them [smaller banks]: Do you have your arms around this problem? Do you have enough capital? Do you have enough liquidity? Do you have a plan? You’re going to take losses here — are you being truthful with yourself and with your owners?” said the Fed’s Chairman.

Stefan Gleason, CEO at Money Metals Exchange, highlights that this trend may extend beyond America: “Central banks the world over are shifting toward monetary easing and lower interest rates, hoping to lessen debt service burdens,” he says.

As Andrei Belov explains, risks are also lower because the US Central Bank has a lot of dry powder to step in and save these institutions as needed. “The Fed can step in with emergency liquidity facilities to prevent bank failures – they certainly seem to have learned their lesson during the GFC,” says the expert.

Dr. Vineer Bhansali ponders, however, that the Fed’s intention may not be to save every failing regional bank. “The Fed thinks of the banks as the main intermediary mechanism for their policies, but in my view, this blanket guarantee only extends to the large money center banks. It is likely that many smaller banks are ‘sacrificed’ in the process of making the overall system safer,” he adds.

Consolidation Is Already a Reality

Against the volatile backdrop, regional banking M&As have already begun to increase over the last few months. According to data from S&P Global, there were ten bank mergers in the United States in January alone, with a total value estimated at approximately $854.6 million.

Among these, Truist Financial (NYSE:TFC), a regional bank headquartered in Charlotte, made headlines by selling its remaining $15.5 billion stake in an insurance arm. Also, Capital One (COF), a credit card lender, revealed its intention to acquire rival Discover Financial Services (NYSE:DFS) for approximately $35 billion.

Jason Langan says that deals like the one reported by Truist may be a viable trend. “While we do not expect significant failures this year, we do think this situation has opened eyes at bank boards and management teams as they consider the long-term sustainability of their operating model and may drive more banks to consider sale or a MOU as a strategic option.”

Dr. Vineer Bhansali adds that another possible driver of further consolidation is the fact that such deals would be positive for the bigger players. But warns that “the better-capitalized banks will likely get a good deal, as long as they don’t abuse the privilege and lever themselves up like NYCB did,” he says.

Which Regional Banks Are in Trouble?

Investors looking for opportunities within the industry via mergers and acquisitions may want to monitor banks with a volatile asset base and outsized interest-rate-sensitive exposure, such as real estate.

“Banks that would fit the profile [for further consolidation] are those with weak loan-to-deposit ratios, a less stable retail deposit base, and a heavy concentration in commercial real estate lending. Not surprisingly, these are also banks whose stock performance tends to lag peers by close to 20% in terms of P/TBV,” says Jason Langan.

Mark Rodgers goes further to name a bank he believes may be on the verge of consolidating soon. “ Valley National Bancorp (NASDAQ:VLY) is one I would keep an eye on,” he says.

Against this backdrop, investors looking for consolidation-driven opportunities may want to take a deep dive into these regional banks portfolios to understand which are the most likely to either fail or spinoff unprofitable operations.

The best - and most affordable way - to do this is by subscribing to InvestingPro for under $9 a month. There, you will find all the latest financial information for all companies in the market.

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Disclaimer: Andrei Belov's views do not necessarily represent the views of his company, Shade Tree Advisors.

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