FRC - First Republic Bank: Uncertainty Just Uncertainty

2023-04-26 09:33:20 ET

Summary

• First Republic Bank has seen huge deposit outflows in the first quarter.
• The real impact of the crisis is only partially seen in the results, as the liquidity crisis happened very late in the quarter.
• Serious investors still have nothing to see here, even as some kind of stabilization appears.

Shares of the First Republic Bank ( FRC ) have lost half their value in the wake of the first quarter results, raising real doubts on the viability of the bank. The degree of deposit outflows shocked investors, as the bank is and remains in a very serious position, with the bank no longer controlling its future (entirely) itself.

A Quick Recap

In the days of the SVG bank demise halfway through March, I last covered FRC, as I concluded that uncertainty prevailed. This came as the bank operated aggressively with regard to deposits, had relatively little liquidity, limited earnings power to increase rates paid to depositors, with many clients holding deposits which exceed the FDIC limit.

Founded in 1985, First Republic is a San Francisco based bank which has seen strong growth in its operations, with assets having five-folded over the past decade. For the year 2022, the bank had grown to a $176 billion deposits base, funded by businesses and consumers, with the company paying an average of 99 basis points on these deposits in the fourth quarter.

Full year interest income rose to $5.7 billion in 2022, up to $1.7 billion in the fourth quarter alone. Borrowing costs rose to $900 million for the year and half a billion in the fourth quarter. The company posted full year operating earnings of around $2.1 billion, leaving about a percentage point to raise deposit rates, before the company turns into lossmaking territory.

Amidst the strong growth in the business, deposits actually rose in dollar terms, but the underlying ratios have deteriorated, as the company ended 2022 with just $4 billion cash. On the asset side, most of the $166 billion loan book seemed tied to residential real estate, as the company had $31 billion in debt securities on the books as well, as the company reported a $4.8 billion unrealized loss on these assets.

This is a huge number, but with a $17 billion equity cushion on a $212 billion balance sheet, it appeared manageable, certainly from a credit perspective. The issue is that this banking crisis is not a big credit event, but a liquidity risk.

With shares hitting a high of $220, shares started 2023 around $140 as they fell to an intra-day low of $45 amidst the SVB crisis, having recovered to $80 when I last covered the shares in mid-March. At the time, I concluded that there was no need to be a hero in such an uncertain environment.

What Happened?

Since mid-March, shares have fallen to the teens as they continued to lose value in the wake of the SVB crisis. Shares traded at $15 in anticipation of the quarterly earnings release, as shares lost another half of their value in the wake of the results, now trading at $8 per share.

On the 12th of March, the bank attracted more liquidity from the Federal Reserve Bank and JPMorgan Chase ( JPM ) , with available and unused liquidity totaling more than $70 billion, essentially creating a backstop, but this of course came at a big cost (to shareholders).

The first quarter results provided few reasons to be upbeat. While the bank posted a decline in first quarter revenues to $1.21 billion, net interest income of $923 million was still substantial, although down from a >$1.1 billion number in the fourth quarter of 2022 and the first quarter of that year. The bank still posted net earnings of $269 million for the quarter, down versus these other quarters, but still profitable.

The issue is not about profitability but liquidity and that is seen on the balance sheet. Between the fourth quarter of 2022, the bank actually grew the loan book from nearly $167 billion to more than $173 billion, but deposits fell from $176 billion to $104 billion. The banks took on more than one hundred in additional short- and long-term borrowings to plug this hole! Moreover, the deposit base even included $30 billion in time deposits made by other banks with the bank!

The bank has taken actions including cost-saving measures, including a 20-25% cut in the workforce, but better is to understand the deposit dynamics. Following huge outflows in March, the company has only seen a 1.7% fall in deposits between March 31 and April 21, despite the cyclical impact of tax season. This is a relative upbeat sign, although it was not mentioned what the usual deposit flow was in "normal" years.

The impact of the higher cost of funding was seen in the P&L as total interest expenses rose to $974 million, up from $44 million in the first quarter of 2022 and doubling nearly on a sequential basis. This only tells part of the story as the impact of all of this was only seen by mid-March. This makes that the higher cost of funding was really only seen in the last 2-3 weeks of the quarter, as the real impact is of course only seen in the current second quarter.

And Now?

Right now the bank still reports equity of $18 billion on $233 billion in total assets and the book value of the shares of around $77 per share suggests that the market believes that the bank is close to worthless, with shares trading at just 10% of the book value. This comes as investors fear perhaps asset impairments, but huge earnings issues as well.

The company has resorted to more than $100 billion in short- and long-term borrowings with average costs of borrowing which exceed the average interest rates received on the asset base, setting the company up for large losses in the quarter to come (after the regular bank expenses). When browsing the website, I find it astonishing that the bank only paid out 1.5% to savings accounts at this moment of writing. Instead, the bank relies on 4-5% cost of debt provided by the Fed.

The likely outcome is that the bank is taken over by the Fed if new uncertainty arises. If the business can shrink its portfolio, it can repay some expensive loans, there might still be some equity left on the balance sheet in such a scenario. That said, I think the bank is too distressed and while the bank might be able to sort out its problems (over time), the question is if politicians and regulators allow the bank to dwindle around for so long. This comes as the repercussions of this uncertainty have greater consequences beyond First Republic, of course.

So long-term investors have few reasons to be involved here as the situation is uncertain at best. That being said, there is potential, but this is very speculative only.

The bank has seen deposit outflows come to a near standstill in April, and if the bank can stabilize the deposit base, can reduce the asset base, and cut its reliance on expensive borrowings, it might have the potential to close part of the gap with reported book value.

That is a highly speculative positioning, however. Serious investors still have no business (as they did not have since March) to be involved here.

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