FRC - First Republic: Relatively Safe Bank Firewall Around It And Extremely Cheap

2023-03-20 12:49:18 ET

Summary

• Regulators are unlikely to let another bank fail, and also they are unlikely to seize a bank based on contagion fears of a systemwide collapse.
• Investors should sell options to make directional bets, as implied volatility is extremely high.
• A buyout is an extremely high probability, so avoid shorting at all costs.
• First Republic Bank is an exemplary model for the banking industry. Its conservative approach to lending and its superb customer service are exemplary for the rest of the industry.
• Unrealized losses are an everyday phenomenon for the banking industry and no reason to panic.

Investors have turned into full panic mode when it comes to shares of regional banks without taking time to analyze the incoming data and make rational decisions. As with any crisis, there are opportunities being created left and right, and as such those, investors who make suitable investments will be rewarded with life-changing returns.

I am betting on First Republic Bank ( FRC ) to make it out of this crisis either through a buyout or as a standalone entity, as I believe the Federal Reserve will soon create a deeply discounted window for borrowing for regional banks if the crisis persists. First Republic is the last pillar holding down the banking sector, and it's imperative for the whole sector to turn it into a success story that needed no government intervention.

The purpose of this article is solely to provide a glimpse into the regulatory framework and also to explain mark-to-market losses. For a complete financial breakdown of First Republic Financials and loan portfolio, please read the article by fellow contributor Daniel Jones.

Banking Regulators Psychology

Banking regulators don't look at all banks under stress the same. Silicon Valley Bank of SVB Financial Group (SIVB) was a bank that took significant inflows of capital from startups and tech companies fully knowing that those startups were burning cash and will soon be asking for that money back. Betting that Venture Capital would keep giving startups funding to deposit at the bank was a very risky bet that exploded on the bank. Knowing the nature of their client's businesses, they should have invested a substantial portion of those funds into short-term treasuries rather than chase the yield in the long term. When regulators look at a bank failure as a result of negligence from management teams to diversify their client base, have a diversified portfolio, and diversify their yield curve, they are unlikely to care about investors in the bank. They kind of want to teach investors a lesson so as not to have pressured banks to make changes. When a bank comes under stress from a panic unrelated to their business practices, as is the case with First Republic, the outcome is what we just witnessed through the infusion of $30 billion from other banks in deposits. Secretary of the Treasury Janet Yellen personally intervened and coordinated a massive infusion of funds into the bank. Did you see all the major banks coming together like that for Silicon Valley Bank? No!

The reason for regulators intervening in one situation vs. the other is very simple, and it comes from a principle established during the 2008 Financial Crisis. That's to not help or bail out poorly managed companies and also to not let another panic in the banking system get out of control. The government understood a very painful lesson when they let Lehman Brothers fail to teach investors and bondholders a lesson. Though regulators have no problem letting the shareholders and bondholders of poorly managed banks lose everything they also understand that if regional banks' shares start collapsing left and right capital will flee the sector and the sector will collapse. Regulators need to give certainty to investors that they won't seize banks overnight and wipe investors over and over. There needs to be some calm in the sector for the sector to finally find its bottom. An increased FDIC deposit insurance should be announced soon by Congress and passed into law.

To conclude this first point. First Republic is a role model for the banking industry. They don't issue credit cards, they don't have exposure to risky car loans, they have superb customer service, and they serve a niche clientele.

Unrealized Losses Explained

Some analysts and rating agencies are making a big fuzz about net interest margin as well as unrealized losses on banks' bond portfolios. This is a natural phenomenon of banks during a credit cycle, and anyone who shows concern about that doesn't understand banking too well. In fact, all banks probably currently have a negative tangible equity value if you were to force every bank to liquidate in real time at the height of a central bank tightening cycle.

See, banks for the last ten years have been lending mortgages at anywhere between 3 to 5% on average. If you are a bank and originated a mortgage last year at a 3% rate and kept the mortgage in your books with a par value of $500,000 with a yield of 3% for 30 years, the present value of that mortgage would drop to $346,275.49 if interest rates were to rise to 5%. But if interest rates were to rise to 7% as they are right now, the bank would be sitting on a $250,000 loss on their books. You can play with the present value of bonds with this calculator .

The cost of keeping that mortgage on any bank's books depends on how much they have to pay depositors in real time to keep their money at the bank. If they now have to pay 4% to keep depositors happy on CDs and those mortgages on their books are paying 3%, the reality is that the bank is getting a double whammy. They are losing on their interest expense and unrealized losses. Now if lending is such a risky endeavor, how is it that banks continue to stay in business? That's because banking is a fluid business. Just as some mortgages originated at 3%, some are being originated in real-time at 7%, and guess what? Those new loans generate more than enough revenue to cover the interest expense on depositors at 4% and make a profit. Banks also have a large number of deposits sitting on checking accounts without carrying any interest associated with them, which is an almost free source of funding for banks.

Unrealized Profits Explained

Just as banks can be sitting on substantial credit losses as interest rates rise, look at what happens when central banks start lowering rates again. If the reverse happens and a bank originates a $500,000 mortgage at 7%, and rates come back down to 3%, the net present value of the mortgage would increase from $500,000 to $895,000 (rounded figures). The bank would be sitting on a $395,000 profit which is substantially higher than the $250,000 loss of those bonds that went from 3% to 7% as rates were rising. As banks originate new loans at higher rates at the peak of a central bank hike cycle when rates normalize - and go lower - the inverse happens too, and banks can make substantial gains on their holdings. That's why banks lend money because they know on every credit cycle, their holdings average against each other. And just as interest net margin goes down when rates go up, as interest rates decrease, interest expense decreases, and the bank's profits dramatically increase.

Fed Induced Wounds

Though credit cycles used to be more regular, the problem is that the Fed has distorted everything from a policy perspective. With almost 15 years of zero percent interest rates rather than a usual 4 to 7-year cycle, banks aren't very well equipped for a massive rate surge. The FED, by raising rates so abruptly it's not giving banks a smooth cycle where rates naturally go higher in small increments as bonds roll over from the balance sheet of banks and are invested at higher rates. I think this last week might have been a wake-up call for the FED, and I expect a policy adjustment going forward to take into account recent events. As mentioned at the beginning, it's very likely that the FED would allow banks to borrow at a discount to the primary rate at a rate that more closely resembles the 10-year Treasury notes. This would reduce the competition that banks have to compete with short-term treasuries and alleviate the effects of a negative inversion in the yield curve.

The credibility of the Private Sector at Risk

If the First Republic crisis can't be contained in a profitable way for all stakeholders in the sector (including shareholders). A market collapse in the sector is going to occur. Nothing is a guarantee in this life, but any of the major banks would rather pay an extra $2 or 3 billion to take over First Republic rather than doing a fire sale that will collapse the whole sector and cause a repricing of the whole banking industry. Calm and a good resolution is in the best interest of the whole sector, and don't be surprised to see all the big banks come together to make sure First Republic stands on its two feet together or is purchased at a significant premium to where shares stand. I don't think a takedown or takeover is even a possibility here.

Summary

First Republic isn't Credit Suisse Group AG (CS) with exposure to exotic products, counterparties risk, years of losses, scandals, etc. A sale of First Republic is unlikely to be at fire sale prices but rather at a premium to where it's trading right now. Any potential bidder knows that this bank is as good of an acquisition as you can get in the market, and the further they wait, the more likely the crisis will be quickly resolved, and the opportunity of acquiring it at a discount will be gone.

However, First Republic Bank is a speculative stock. And the unimaginable sometimes happens in times of stress. The Bank could be sold for pennies on the dollar if the sector continues to struggle. However, the accurate calculation of the fair price of this bank isn't on HTM losses but instead on the reputation, branches, staff, portfolio risk, etc. The clientele, location, and asset quality of this bank make it an easy target for any other bank or Private Equity firm.

I am playing First Republic Bank via options. Currently, weekly options are yielding over 20% for a week's worth of risk. For example, weekly $15 puts are trading for $3 per contract. This would allow you to buy the stock at $12 dollars. I sold those contracts on Friday, and I am betting that the stock doesn't decline further beyond the $15 mark. I hope to be assigned stock at that price, but if not, it would at least be an excellent trade with some downside protection.

For further details see: