UBS - First Republic Bank: Fed Strikes Back

2023-03-30 12:00:00 ET

Summary

• It’s safe to assume that First Republic Bank has become too important to fail and the government along with the Fed would continue to back it in the future.
• At the same time, the expansion of various emergency lending facilities by the Fed ensures that there’s a high chance that we’ll avoid a systemic liquidity crisis.
• As such, I believe that the recent bank run has been contained and investors should start exploring opportunities in the banking sector.

If a week ago there were still questions about whether First Republic Bank ( FRC ) would be able to avoid a liquidity crisis, then the expansion of various emergency lending facilities along with the additional injection of liquidity is making it possible for the bank to survive and continue to operate as it became too important to fail. At the same time, there's a case to be made that after experiencing over 90% depreciation, First Republic Bank shares now represent an upside at the current levels as the recent moves by the Fed are likely to help the bank to weather the ongoing crisis and ensure the creation of additional shareholder value in the foreseeable future. Therefore, recently I've opened a long position in First Republic Bank as I believe that the bank run has been contained, and we'll be able to avoid a systemic liquidity crisis anytime soon.

The Story So Far

Back on March 12, Seeking Alpha published my article on SVB Financial Group ( SIVBQ ) which argued that the government along with the Federal Reserve needs to step in and figure out a plan to contain the ongoing bank run to prevent the emergence of the new systemic crisis that could bring the entire financial system to its knees. While it was too late to save SVB, there was still time to help other regional banks such as First Republic Bank, which lost $70 billion worth of deposits while its stock lost over 90% of its value, from going under.

The main difference between First Republic Bank and SVB was the fact that the former serves mostly a different demographic group and only ~79% of its deposits were uninsured while the latter had over 90% of its deposits uninsured. Thanks to this different deposit basis, First Republic Bank was able to sustain the initial bank run and live long enough until a solution was found which ensured that it won't face a liquidity crisis and will continue to operate for the time being.

On March 16, a week after SVB entered the FDIC receivership, the biggest American banks announced that they will inject $30 billion worth of liquidity in the form of deposits into First Republic Bank to ensure that it would be able to avoid becoming insolvent. At the same time, First Republic Bank has also raised additional funds via the Fed's discount window to have enough liquidity to ensure that it survives another bank run.

Despite this, there's always a risk that the holders of its stock could nevertheless lose their investments if the bank is forced to be sold or enters the FDIC receivership, as was the case with SVB. There were already reports last week that the management of First Republic Bank could look for ways to sell the bank's assets if a further capital raise fails. Considering how equity holders of Credit Suisse Group ( CS ) lost nearly everything during the forced sale of their bank to UBS Group ( UBS ), there's still a possibility that the shareholders of First Republic Bank might face the same fate.

However, I tend to believe that that's not going to happen anytime soon as it appears that the banking crisis has been contained so far and the risk of First Republic Bank going under is significantly lower in comparison even to a week ago.

Too Important To Fail

The latest banking data , which was released only a few days ago, indicates that smaller American banks in the last week lost ~$108 billion worth of deposits, most of which went to the biggest systemically important banks that are better capitalized and are too big to fail. What's also important to note is that not only the First Republic Bank but also most other regional banks in the country have major unrealized losses on their investment securities due to the rising interest rates that negatively affected their portfolios.

As such, it's safe to assume that the First Republic Bank is seen as a current poster child of the recent bank runs as it became the first bank that was saved after the SVB, Silvergate, and Signature were let go. If the government along with the Fed will let it fail after all the efforts to inject more liquidity into it, then there's a high chance that all the other regional banks would experience even greater bank runs as it would be a sign that all of the deposits above the $250,000 threshold are not secured at all.

That's why I think that the government along with the Fed will continue to inject additional liquidity into the bank for as long as it takes, and the latest report about the expansion of the emergency lending facility shows that First Republic Bank has likely become too important to fail at this stage.

On top of all of this, it's also important to note that the introduction of the Bank Term Funding Program ((BTFP)) by the Federal Reserve a few weeks ago also played a big part in ensuring that First Republic Bank along with its peers would not go under. Thanks to this new facility, banks no longer are forced to engage in a fire sale of their portfolios to shore up liquidity to meet deposit outflows, as they could get funding directly from the Fed and use their investment securities as collateral at their par value. As a result, banks like First Republic Bank don't need to take a haircut on their portfolios and realize losses, which wasn't the case for SVB when it was engaged in a fire sale of its securities to cover deposit outflows. Thanks to the introduction of BTFP, I believe that we're unlikely to see a systemic liquidity crisis and that's also one of the reasons why First Republic Bank is likely to remain operational in the foreseeable future.

The Endgame

It appears that the Fed's endgame is to expand its balance sheet for a while to help banks survive until it decides to pivot and start decreasing rates, which would then lead to the moderation of unrealized losses of existing securities that banks gave it in exchange for additional liquidity.

If that's the case, and I believe that it is, then the main question now is what First Republic Bank's fair value is in the current environment. And that's where the real problem lies. Considering that the bank itself hasn't stated how many billions of dollars' worth of deposits it lost, as the $70 billion number was initially reported by The Wall Street Journal citing its own sources, we don't know how many customers the bank lost and how big of an outflow was.

At the same time, it also makes no sense to use the latest earnings report for FY22 to look for answers, as it's safe to assume that First Republic Bank's current book value is significantly lower than the book value of $75.38 per share at the end of December. We'll have a better understanding of the bank's current state of affairs in the following weeks when it reports its Q1 earnings report that's scheduled to be released on April 13.

However, after experiencing over 90% depreciation of its stock, there's a case to be made that First Republic Bank has an upside at the current levels as it was able to avoid a liquidity crisis, and it will likely be able to survive thanks to having the backing of the government and being able to access various emergency lending facilities. Considering that JPMorgan ( JPM ) is bullish on the bank's stock after injecting its own liquidity into it, I decided to follow Warren Buffett's advice of being greedy when others are fearful and went on a buying spree and added banks such as First Republic Bank, Deutsche Bank ( DB ) and Charles Schwab ( SCHW ) to my portfolio as all of them have become too important to fail.

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