Since the collapse of SVB Financial and Signature Bank, as well as the forced acquisition of Credit Suisse, there have been some signs that the banking sector is stabilizing, although it is still too early to tell. However, one bank that continues to struggle is First Republic (FRCB), which saw its shares whip up and down as the market tries to get a handle on the rapidly evolving situation. First Republic experienced elevated deposit outflows and credit downgrades from the rating agencies.
While the bank has made several attempts to try to shore up confidence -- and received a massive deposit injection from some large U.S. banks -- I think First Republic could be in real trouble right now. Here's why.
Trying to plug up First Republic's deposit outflows
Like SVB, First Republic had a lot of uninsured deposits. It was also serving high-net-worth individuals and businesses that could pull deposits at a greater rate than most other more traditional regional banks. First Republic also had about $4.8 billion of unrealized losses in its held-to-maturity (HTM) bond portfolio, which have not been subtracted from the bank's equity yet. The bank had about $12.8 billion of tangible common equity at the end of 2022.
Various media outlets such as The Wall Street Journal report that First Republic had about $70 billion of deposit outflows, which equates to about 40% of its total deposit base. Some analysts put the estimate even higher. First Republic's goal is to not have to sell its bonds while they trade at a loss to cover deposit outflows because that would wipe out a significant amount of shareholder equity.
The bank has been trying to plug the deposit hole with higher-cost borrowings. It is also building its cash position to be able to stay flexible and deal with deposit volatility. On March 16, First Republic reported that it received $30 billion of deposits from 11 of the largest U.S. banks.
It also reported having a cash position of $34 billion, not including the $30 billion of deposits it had just gotten from the large banks. Between March 10 and March 15, First Republic drew borrowings from the Federal Reserve in the staggering range of between $20 billion and $109 billion. These overnight borrowings carry an overnight rate of 4.75%. First Republic also said it had increased short-term borrowings from the Federal Home Loan Bank by $10 billion at a cost of 5.09%.
How this will pressure First Republic's margin
A key metric to watch as it relates to bank profitability is the net interest margin (NIM), which essentially looks at the difference between what a bank makes on interest-earning assets such as loans and securities, and what it pays out on interest-bearing liabilities such as deposits and borrowings. Here's a look at First Republic's assets at the end of 2022.
Image source: First Republic Annual Report. Note: Dollar figures are in millions.
First Republic's securities book had a weighted yield of 3.19%, while the bank has a $92 billion loan book of mortgages yielding 2.89%. Roughly 37% of the bank's loans were also fixed-rate loans at the end of 2022, while the heavy remainder have hybrid rates, meaning they are fixed for between one and 10 years and then adjust. So the bank's interest-earning assets are not in the best position given where broader interest rates and bond yields are. Now, here's a look at First Republic's liabilities.
Image source: First Republic Annual Report. Note: Dollar figures are in millions.
The $70 billion-plus in outflows has likely come from the bank's $75 billion of non-interest-bearing deposits, which the bank pays no interest on, or cheaper interest-bearing sources like checking accounts or money market accounts with lower interest rates. The bank has now had to replace these lower-cost funds with $10 billion of short-term borrowings yielding more than 5% and some high number of funds from the Fed's discount window yielding 4.75%. The bank is also likely paying a market rate of 4% or 5% on the $30 billion of deposits it just received from the 11 U.S. banks, which must stay in First Republic for about four months.
So, while the actual modeling is quite complex because of all the moving parts, I think it's fair to assume that First Republic's cost for its interest-bearing liabilities is going to soar in the first quarter of the year and perhaps later this year as well, while its interest-earning assets won't see their yields rise by nearly enough to offset the huge step up in funding costs. The increase on the asset side of First Republic's balance sheet may end up being more minimal, given its loan composition. This should really put a dent in First Republic's near-term earnings and perhaps lead it to report a big loss, which would eat into its capital position.
Not a lot of good options for First Republic
Based on news reports, it seems like First Republic is having a tough time with strategic options, which include finding a buyer or raising capital. While the bank had quite a strong business and was a very strong-performing stock over the years, First Republic is currently sitting on billions in unrealized loan losses that an acquirer would need to deal with.
There have also been reports that First Republic may look to downsize its balance sheet by selling certain businesses or loans. But given the low-yielding, long-duration nature of many of its loans, the bank would likely have to sell those at a discount and take losses.
The only hope for the stock, from what I can tell, is if it can somehow get most of its clients to bring their lower-cost deposits back to the bank, and I just have no idea how feasible that is. I don't know if it's impossible, especially if the government makes some kind of guarantee on deposits, but I'm certainly not going to bank on it. Given these near-term challenges and the chance that the bank either gets bought at some kind of bargain price or does a highly dilutive capital raise, I would advise looking for other opportunities in the banking sector.
