R. Christopher Whalen
Apr 22, 20226 min
April 22, 2022 | Premium Service | With this edition of The Institutional Risk Analyst, we return to a couple of interesting banks with roots in the mortgage industry, but that’s where the similarities end. Silvergate Capital (SI) and Western Alliance Bancorp (WAL) were two of the best performing bank stocks of 2021, but both are now following the bank group lower and for different reasons. The former is being hurt by flagging interest in crypto assets, the latter by the nuclear winter in housing caused by the lurch in Fed interest rate policy. Where is value for these two names and the broader banking sector?
Source: Google
Western Alliance Bancshares (WAL)
We profiled WAL early last year, just as the bank had closed its acquisition of AmeriHome from Apollo Global (APO) portfolio company Athene (ATH). In those happy days, AmeriHome was raking in the profits from QE, with gain-on-sale margins for conventional loans in the 3-4 point range.
There are virtually no conventional lenders in the US today that are profitable when they sell a loan into the secondary market. Why? Because forward prices (yields) in the too-be-announced (TBA) market are galloping higher and faster than the advertised annual percentage rates for residential mortgages. This is significant for WAL and AmeriHome because they are among the largest aggregators of conventional loans along with PennyMac (PFSI).
Specifically, instead of trading at 3-4 point premiums to par, TBAs for current production are at a 1-2 point discount. This means that every loan being sold into a conventional MBS today is a dead loss for lenders. Notice in the screenshot below from Bloomberg that the only TBA shown above par are FNMA 4.5s, meaning that many lenders are losing money on every loan sold into the secondary market.
This past week we saw several conventional loan pools with 700+ FICO scores on average and weighted average coupons (WACs) above 6%, in some cases near 7% coupons. These pools were sold into 6% FNMA securities for delivery in May, a TBA contract that is not yet even shown on the Bloomberg screen.
We also saw two pools of non-QM jumbos that priced above 101.87 with WACs above 7.5%. What is suggests is that mortgage rates are already above 6% effectively, but the insane competition in the shrinking market for conventional loans is holding down prices and annihilating a market with 50% over-capacity.
WAL saw net down slightly in Q1 2022 vs Q4 2021 at $240 million, with net interest margin of 3.3%. The bank continues to be one of the best performer in Peer Group 1 measured by metrics such as efficiency and credit. WAL reported zero charge offs in Q1 2022 and showed delinquent loans at just 0.15% of total loans. Shareholder equity rose by $1.3 billion YOY, a reflection of the bull market in housing assets that is now sadly a fast fading memory.
We don’t have any stability concerns for the $55 billion asset WAL as we enter a period of uncertainty over interest rate policy and great market volatility. The bank’s held-for-investment loan portfolio has grown enormously (43%) YOY, but deposits have also increased by 36% due to the massive mortgage escrow balances controlled by AmeriHome.
The impact of the AmeriHome acquisition is clearly visible and largely in a positive way, but we look for loan volumes at WAL to fall sharply in 2022 along with the rest of the mortgage industry. At 1.6x book value at the close today, the stock is not cheap but it is down from 2.6x a year ago when it outperformed most large banks.
Silvergate Corp (SI)
We profiled Si back in February of this year, but much has changed in the past several months with interest rates up and crypto valuations falling. SI was trading at 12x book value at the end of Q1 2021, but today the stock is trading around 2.5x, a significant drop YOY, but SI is up sharply from a month ago. Note that SI has a beta of 2.5x the average market volatility, a function of the crypto component in the stock’s audience. WAL by comparison, has a beta of 1.5x and the KBW Bank ETF has a beta of 1.3x.
There are clearly some investors who are still bullish about the SI crypto business. For us, the big change in the mix is the declining attractiveness of the crypto trade as the FOMC raises interest rates dramatically, providing a tangible alternative to crypto assets as a shelter from financial repression.
If you think of SI, Tesla (TSLA) and all of the MEME stocks as a reflection of real interest rates, the timing of the down move in SI begins to make some sense. Or to put it another way, a year ago SI’s market valuation was inflated by expectations regarding the profit potential of crypto, but today such expectations are greatly reduced.
While the bank continues to grow income and its customer base, the flow of crypto transaction across its proprietary SEN network fell dramatically in Q1 2022, as shown in the table below from the SI Q1 2022 earnings presentation.
Given the small size of the depository, SI is obviously not of interest to investors because of its community banking or legacy mortgage business. With $16 billion in total assets (vs less than $2 billion in 2019) and an unusual liability structure, SI’s bank unit is idiosyncratic to put it mildly. As and when the blown falls off the crypto rose entirely, we suspect that the bank could shrink back down to ~ $2 billion in assets.
The continued attraction of SI for investors is clearly crypto, but we still don’t see the profits to support the risk of crypto involvement. The swooning volumes in the world of crypto currencies is an important factor for investors and risk counterparties to consider. The table below is from the latest SI earnings presentation.
We have previously expressed concerns about SI’s business model, both in terms of the composition of the bank’s balance sheet and the risk to the bank posed by extensions of credit with crypto assets as collateral. The torrid growth rate for the bank’s assets, which are mostly invested in agency securities, is another obvious red flag. The non-interest income side of the ledger is clearly the point of attention for investors, yet this metric declined in Q1 2022. The chart below is from the SI earnings presentation.
With the explosion of the war in Ukraine and related sanctions against Russian nations and institutions by the US and other nations, counterparty risk must also be considered when assessing the risk profile of SI. Suffice to say that anyone involved in crypto trading and other services in the US, onshore or offshore, must have a know your customer (KYC) and anti-money laundering (AML) regime in place to avoid violating US sanctions or face serious legal repercussions. This tiny community bank in Southern California may be along the casualties of the latest convulsive lurch in FOMC interest rate policy.
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