FRC - First Republic Bank: Existential Risks Are Real

2023-04-29 02:32:02 ET

Summary

• First Republic Bank reported major deposit withdrawals for the first-quarter on April 24, 2023.
• The bank is looking at asset sales to repair its balance sheet or try to sell itself to a top tier bank.
• Book value discount reflects that the market is very pessimistic.

I covered First Republic Bank ( FRC ) in March -- Buy When There Is Blood Is In The Street -- and labeled the bank a high-risk, high-potential investment in the U.S. regional banking market as I believed that the Fed’s emergency liquidity facility presented an effective liquidity backstop for community banks that were seeing elevated levels of deposit flight. First Republic Bank reported first-quarter results on April 24, 2023 which showed that the bank lost approximately $72B in deposits as especially venture companies pulled their funds from the bank. Although a consortium of banks decided to put $30B of their money as uninsured deposits into First Republic Bank to shore up market confidence, it now looks likely that the bank will have to flee into the arms of a top tier bank!

Negative deposit trends and huge increase in short-term borrowings to make up cash shortfall

First Republic Bank saw a 41% decline in total deposits in the first-quarter as investors panicked about the safety of deposits at community banks that had a large amount of uninsured deposits (those exceeding $250,000). In Q1’23, First Republic Bank saw $72B of its deposits go out of the door. The amount of deposit withdrawals has been excessive, to say the least, and has been larger than I expected. Other community banks including Western Alliance Bancorporation ( WAL ) and PacWest Bancorp ( PACW ) have seen their deposit flows stabilize and in both cases depositors returned with funds after the end of the quarter. Due to the recovery in deposits, I believe PacWest Bancorp is a promising turnaround stock for 2023 .

However, First Republic Bank, which had a strong venture arm pre-crisis, saw a significant de-risking of its deposit base as well: the percentage of insured deposits as a percentage of total deposits increased from 33% at the end of FY 2022 to 52% at the end of Q1'23.

First Republic Bank also saw a significant increase in its short-term borrowings due to the crisis that hit the bank in the first-quarter. In Q1’23, First Republic Bank added $74B in new short-term borrowings to its balance sheets… which is effectively the sum the bank lost in deposits.

Alternative options for First Republic Bank

To deal with extraordinary liquidity challenges, the bank has said that it is exploring the potential sale of $100B worth of its assets. The bank also said that it will cut up to 25% of its workforce as it seeks a hard restructuring in the wake of its deposit crisis. Given the massive amount of deposits leaving the community bank, it is at this point questionable if First Republic Bank can remain an independent bank. I believe it is likely that First Republic Bank will be sold to a top tier bank in order to prevent a collapse. As potential buyers I could see Bank of America ( BAC ), Wells Fargo ( WFC ) or JPMorgan Chase ( JPM ) which have large deposit bases themselves and which could integrate First Republic Bank quickly into their operations. Alternatively, First Republic Bank could sell some of its loans or securities, but would likely have to do so at a loss... which won't help investor confidence either.

According to a SA news item , the U.S. government, the Fed and the Federal Deposit Insurance Corporation are working on a deal to save First Republic Bank. If the FDIC seizes First Republic Bank, other banks could bid on the bank's assets and acquire the company. In this event, however, the equity would most likely be worthless.

First Republic Bank: valuation indicates that the market sees the bank’s equity as worthless

First Republic Bank has been the community bank hit most by the unravelling of Silicon Valley Bank last month. FRC stock is currently trading at just about $6, a huge change compared to the $170 per-share valuation seen just a year earlier. The implied discount to book value right now exceeds 90%, meaning investors essentially expect the bank to have no equity value anymore.

Risks with First Republic Bank

The risks with First Republic Bank are obvious and the bank may now be perceived as a bad bank that needs to rescue itself into the arms of a stronger financial enterprise, quite possibly under pressure from the Fed which is trying to prevent the bank crisis to spiral out of control. Considering the high level of deposit outflows in the first-quarter, it is likely that remaining equity holders won’t receive any value if the bank was forced to sell itself.

Final thoughts

I own up to my mistakes when I make them. My position in First Republic Bank was a speculative one and I limited my risks by only investing about 1% of my portfolio, an investment that I was prepared to lose. Obviously, I made a mistake betting on First Republic Bank being able to survive and the amount of deposit outflows proves to be a very large challenge. Other banks like PacWest Bancorp or Western Alliance Bancorporation have fared better and seen decreasing risks in their deposit base (and I am in the green on those investments). Despite $30B of emergency deposits by a consortium of banks in March, First Republic Bank has seen material deposit outflows in Q1'23. A Fed-assisted fire sale to a top tier bank is the most likely outcome at this point, in my opinion, and it may result in equity holders losing their entire investment!

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