WFC - First Republic Bank: Could Avert The Breaking Point (Rating Upgrade)

2023-03-17 09:30:57 ET

Summary

• First Republic Bank received a $30B deposit injection from 11 leading U.S. banks, including JPMorgan Chase. The Janet Yellen-orchestrated move is intended to bolster depositors' confidence.
• However, a dividend suspension led to another post-market rout, as income investors will likely move to the sidelines.
• First Republic is facing a dire situation, with its funding costs set to surge after suffering a downgrade, higher borrowing costs, and a massive deposit injection.
• The panic-induced selloff has dealt such a devastating blow that investors have been hit hard, with losses stretching all the way back to the lows of October 2011.
• For those with a high-risk tolerance, an attractive speculative opportunity may be on the horizon - but only if the First Republic can somehow survive the ever-present threat of a bank failure.

Significant developments have taken place just a few days after the collapse of Silicon Valley Bank of SVB Financial Group ( SIVB ) and Signature Bank ( SBNY ) engulfed First Republic Bank ( FRC ).

In our previous article, we highlighted that FRC faces an inherent risk that already took down SBNY and SIVB: a sudden takeover by the FDIC in anticipation of bank failure wiping out investors and owners in the process.

However, recent moves by its banking peers, regulators, and the U.S. government appear consistent with media reports suggesting a systemic, broad-based bank run in weaker banks could happen.

As such, it could have threatened the failure of even more banks, resulting in potentially uncontrollable consequences and inflicting untold damage on the U.S. economy and financial system.

The WSJ highlighted FRC in an exclusive , highlighting the events that led to the decision by regulators and the U.S. government to rescue all SVB and Signature Bank depositors, including uninsured deposits.

Signature Bank underwent tremendous stress, as it "began to see significant outflows of uninsured depositors" after SVB went into receivership on Friday.

Furthermore, real-time data at the Fed on Saturday showed that "regulators were seeing signs of massive deposit outflows from more than 20 midsize banks." As such, it ultimately convinced the Fed and the U.S. government that they needed to label the crisis as a systemic event requiring "urgent intervention."

Therefore, we believe the stakes have changed dramatically.

Treasury Secretary Janet Yellen orchestrated the $30B of deposit injection into First Republic Bank, led by JPMorgan Chase & Co. ( JPM ), and the biggest Wall Street banks: Citigroup Inc. ( C ), Wells Fargo & Company ( WFC ), Bank of America ( BAC ) contributing $5B each. In addition, Morgan Stanley ( MS ) and The Goldman Sachs Group, Inc. ( GS ) pitched in with $2.5B each as part of the coordinated response from 11 leading U.S. banks to shore up First Republic Bank's deposit base.

With over two-thirds of its deposits uninsured, the bank is in a precarious position to navigate a further fallout, even though it had access to a credit line worth $70B.

Hence, the deposit injection from its banking peers should help stem the confidence crisis, reducing the risks of an abrupt bank run leading to the need for the FDIC to step in and close the bank.

A critical difference in the sequence of events led to SVB's downfall. SVB was compelled to conduct an ill-fated capital raise given the impending " multilevel downgrade " by Moody's.

However, First Republic Bank's ratings have already been downgraded to " junk. " As such, the market should have already priced in the downgrade, forcing investors to bail out recently.

Also, instead of conducting a capital raise first to shore up the balance sheet , First Republic Bank received a much-needed deposit injection to stem outflows and attempt to restore depositors' confidence.

Given the recent events, we believe it indicated that the U.S. government, the Fed, and the U.S. financial system remain steadfast in standing in line with FRC to defend its solvency.

The US could have been encouraged by the positive reaction to Credit Suisse Group AG ( CS ) stock. Its banking regulator pledged liquidity support to the struggling bank to " reassure the market that the bank will not fail anytime soon."

Notwithstanding, the recent developments are not without cost. We believe First Republic Bank will be beset with higher funding costs to appeal to customers to return/stay, worsened by its rating downgrade.

Hence, the dividend suspension , which led to a post-market rout, likely alienated income investors looking for yield amid the stock price collapse.

Hence, we believe it's prudent to reassess its earnings trajectory. Moreover, the bank is primed to conduct a thorough reassessment, as it's " focused on reducing its borrowings and evaluating the composition and size of its balance sheet going forward."

As such, the recent borrowings the bank tapped from the Fed to bolster its defenses, coupled with the $30B deposit injection, will likely impact its near-term earnings trajectory.

Given the tremendous uncertainty right now, it remains to be seen whether FRC could recover its growth premium.

Based on yesterday's close, FRC last traded at an NTM normalized P/E of 5.7x, expected to fall further to 4.7x, based on its post-market battering. It's well below its peers' median of 7.3x (according to S&P Cap IQ data).

However, given the headwinds highlighted earlier, we believe the market has likely priced in significant earnings cuts.

As such, the price action could potentially bottom out here. Dividend investors will likely bail following the dividend suspension announcement. Next, investors who held the stock from October 2011 were also hit, as the selling overdrive took out those levels seen in the above chart.

Despite that, with the Fed, the U.S. government, and its banking peers seemingly committed to defending FRC from falling into a failure scenario, we believe the most critical risk - bank failure - looks less likely compared to a few days ago.

Hence, we believe it's appropriate for investors looking for a speculative opportunity to buy the panic to assess the possibility of adding positions.

However, we must stress that there isn't any price action validation signal yet supporting a robust entry signal.

Also, the risk of failure cannot be ruled out, which could wipe out your investment if you choose to add.

Consider these risks carefully, even if you are keen to exploit the extreme pessimism in First Republic Bank. However, if it survives, the reward/risk seems attractive.

Rating: Speculative Buy (Revised from Hold).

Note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. Our cautious/speculative ratings carry a higher risk profile. They are only intended for sophisticated investors/traders. We urge new or inexperienced investors to avoid relying on such ratings. Moreover, investors must exercise prudence and devise appropriate risk management strategies, such as pre-defined stop-loss/profit-taking targets, within a suitable risk exposure.

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