WAL - First Republic Bank: Battered And Bruised But Still Liquid

2023-03-14 09:35:26 ET

Summary

• First Republic Bank's shares have been hammered on fears that the bank will see a run on its deposits push it into failure, as what happened at SVB and Signature.
• First Republic is in relatively better shape, including a higher ratio of tangible equity to unrealized losses and more diverse deposits and funding.
• Higher funding costs are almost certain and First Republic would do well to pull back on lending and rebuild a liquidity cushion, but that will impact earnings.
• I believe FRC is an earnings story more than a survival story, but the bank is not out of the woods if another wave of panic hits the market.

The last week has seen banks, and growth-oriented banks in particular, plunged into chaos in the wake of SVB (SIVB) openly disclosing its liquidity issues and need for capital and then seeing an unrecoverable run on deposits as companies rushed to pull their money. Shortly after, Signature Bank ( SBNY ) likewise collapsed, and investors have gone into full panic over the risks and survivability of many banks perceived as having similar models and risks – including First Republic ( FRC ).

There are a lot of valid questions to ask right now about First Republic. I would expect many readers to be wondering, “is my money safe at First Republic?”, “Is First Republic at risk of collapse?” and so on. The Fed, FDIC, and U.S. Treasury seem to have established precedent now that all depositors (insured and uninsured) will be made whole, so I believe that substantially reduces the risk to depositors and the need to move money away from the bank. That said, as we have seen in the last week, any bank below that “systemically-important” threshold is arguably at risk of collapse if deposits choose to run en masse.

As far as the investment credentials of First Republic go, I believe this is a high-quality bank that leaned too far out over its skis, got caught short on liquidity, and will pay a heavy price (literally) for this. First Republic’s funding costs are going to increase meaningfully, the loan growth is very likely going to shrink, and the risk premium factored into the valuation will be elevated for some time. I do think that First Republic is undervalued relative to what I hope is a worst-case scenario, but again I point to SVB and Signature as examples that you can never entirely rule out a zero-case outcome.

A Different Deposit Mix Should Help First Republic Bank

There are certainly some similarities between SVB and First Republic, but I believe there are also meaningful differences, particularly in the deposit base and operating philosophy. First Republic has prioritized customer service and satisfaction to a nearly obsessive level and has likewise focused on long-term banking relationships – this isn’t to say that SVB wasn’t concerned with customer service and didn’t likewise prioritize long-term relationships, but in my opinion SVB was always a more transactionally-oriented institution.

In any case, the deposit bases are quite different. Technology companies (broadly defined) made up close to 80% of SVB’s deposits, versus around one-third of PacWest ’s ( PACW ), 12% of Western Alliance ’s ( WAL ), and just 4% of First Republic’s. Likewise, both SVB and Signature had exceptionally high levels of uninsured deposits – over 70% of deposits in both cases – while uninsured deposits were about 56% of year-end deposits at First Republic (46% at WAL and 43% at PACW) and in the 30%’s for most comparable mid-cap banks. Given this, there has been less urgency from companies pulling their deposits from First Republic (and/or VCs advising their portfolio companies to do so).

I do expect meaningful changes in deposits going forward. Banks are almost certainly now going to spend up for deposits that are stickier, and I expect that banks will also look to diversify their deposit base even more, though First Republic’s is already rather diverse. With that, I expect a meaningful increase in deposit costs.

I would note again, though, that the decision on the part of government officials to guarantee all deposits at SVB and Signature (insured and uninsured) is a big step that should reduce the urgency to pull deposits from smaller banks. I do expect to see a surge of deposits toward the biggest and most stable banks ( Bank of America ( BAC ), Citigroup ( C ), JPMorgan ( JPM ), PNC ( PNC ), et al), but I do think backstopping these deposits in full meaningfully reduces the risk of another run collapsing another bank.

A Different Mix Of Earning Assets And Loss Exposures

Is First Republic safe? Is First Republic at risk of collapse?

These are very fair questions to ask at this point. Before going further, I want to reemphasize that you can only get so far with reported financials (including management updates) and analysis – if depositors move in unison (as major VCs did with SVB), I’m not sure how many sub-$250B banks could withstand a run on their deposits. The difference with banks like First Republic is that they have comparatively more diversification among their depositors (a larger number with smaller balances), reducing the risk of concerted actions.

I also see less pressure and risk on the tangible equity of First Republic. The bank does have a fundamental problem – it has grown aggressively (including raising equity in recent years to fuel that growth), locking itself into large amounts of fixed-rate loans at low rates (single-family mortgages, mostly) ahead of a substantial increase in funding costs. While it was before my time as an analyst, there are echoes here of the early stages of the S&L crisis of the 1980’s, where many small banks similarly got trapped by excessively growing their asset base with low-yield loans ahead of a period of rising rates.

Still, there are important differences.

Securities are only 15% of First Republic’s earning asset base, versus almost 60% at SVB and around 25% for the midcaps as a group, and only about 10% of those are considered available for sale. With that, unrealized losses here (including held-to-maturity securities that theoretically shouldn’t be sold at a loss) are only about one-third of tangible common equity versus almost 130% at SVB. This is not an end-all be-all metric (Signature was only at around 10%), but there’s much less risk here from First Republic needing to liquidate its securities at a loss.

This is also where the new Bank Term Funding Program matters. The government has stepped up to offer funding (loans) of up to 1 year against collateral including U.S. Treasuries, mortgage-backed securities, and similar qualifying assets at a rate equal to the overnight indexed swap (or OIS) rate plus 10bp. Importantly, the collateral is being valued at par, significantly reducing the need to sell securities at equity-depleting losses.

The Outlook

First Republic does have a fundamental mismatch between its assets and its liabilities, but the gap in yields between securities, loans, and deposits isn’t as severe as it was at SVB, and the cushion of tangible common equity is thicker. With liquidity sources of around $70B (including the BTFP and financing from JPMorgan), I see First Republic’s risk much more on the margin/earnings side than on survivability. Again, I include the caveat that if depositors lose faith and pull a substantial portion of their deposits at once, there’s not much First Republic can do.

As far as the earnings go, I expect to see meaningfully higher deposit costs as First Republic will have to compete more aggressively for core deposits. I do also expect to see the bank look to lock in more liquidity through debt financing. At the same time, I expect to see loan growth slow and the bank look to rebuild its loan/deposit ratio toward 75% to 80% versus the 95% of the last quarter. I don’t expect meaningful loan sales to accelerate that process, as the mark-to-market process could exacerbate some of the issues.

Without knowing the full cost of these changes, nor how management intends to respond to these challenges (I’m assuming loan growth is pulled back significantly, but they haven’t said as much yet), my model is even more speculative. My prospective changes drop my ’23 EPS estimate to $4.96 (from $6.17) and my ’24 estimate to $6.76 (from $8.46). I’ve also increased my discount rate to 13% in the near term to reflect the elevated operating and sentiment risks – far higher than a bank of this quality would otherwise merit.

With those changes, I get a fair value of around $100 on long-term discounted core earnings and around $52 using a 10.5x multiple on my ’23 EPS estimate (half my former multiple and in-line with the pre-panic norm for midcaps). Should the bank navigate through these treacherous waters, I expect that $50-something fair value to be exceptionally low, but then I don’t think I’d have predicted that SVB would be run into receivership two weeks ago.

The Bottom Line

If you’re a depositor at First Republic, I think you can rest easy, but it’s not my money and I understand if a “better safe than sorry” mentality leads people to move their funds to banks seen as safer. If you’re an investor, I think you’ve already seen the worst, but there is still an exceptional amount of fear and uncertainty out there right now. I believe First Republic survives and I believe that while some of management’s growth ambitions need to be rethought, the basic model here still works. Whether that makes the stock a “buy” for you depends in very large part on your appetite for risk and whether you see another liquidity crisis on the horizon.

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