FRC - Guilty By Association: First Republic Bank

2023-03-20 13:14:13 ET

Summary

• Recent bank collapses have spooked investors, with the overall banking industry taking massive losses this week.
• Although the spotlight is being cast on Silicon Valley Bank and Credit Suisse Group AG, they have had problems lingering for quite some time.
• First Republic Bank shares have fallen 80%, but the bank maintains a healthy balance sheet, as shown through their available-for-sale securities when compared to its equity.
• First Republic Bank shares have been oversold and pose a unique buying opportunity.

Investment Thesis

First Republic Bank ( FRC ) is guilty by association when looking at the recent bank collapses. Silicon Valley Bank of SVB Financial Group (SIVB) collapsed due to risk management negligence with regard to the duration of their deposits vs. available-for-sale securities. In the case of Credit Suisse Group AG (CS), problems have been lingering for quite some time, and this should come as no surprise. When looking to First Republic Bank, they have maintained adequate levels of available-for-sale securities with respect to equity, have an impressive 29% Net Income margin, and have seen 11 major U.S. banks deposit $30 billion into their banks this weekend.

Recent Bank Collapses

Bank runs and fear of banks collapsing have been the headlines everywhere this week. Most prominently, three names have been featured recently in the news with their stocks declining significantly; Silicon Valley Bank, Credit Suisse, and First Republic Bank. All of these banks outlined above are failing for different reasons, which I will explain below.

Silicon Valley Bank

Silicon Valley Bank is a bank that catered towards venture capital and startup ideas. Traditionally, it has been very hard to find banks willing to accept large deposits from VCs because they are typically considered a "cash burn" business. They need high amounts of liquidity, and these companies hold considerable risk when compared to traditional banking clients. Since SVB has a higher need for liquidity due to their client base, bank runs were always an issue due to liquidity issues of the depositors. This problem was exasperated by the fact that SVB had more available-for-sale securities than equity in their bank. Available-for-sale securities are priced by discounting the future cash flows of the contractual rate of the for sale securities by current market interest rates. Since market interest rates have been rising at the fastest pace in history, while SVB was holding treasuries yielding in the 2%-3% range, the price of their available-for-sale securities dropped dramatically.

Due to the recent runs on banks, SVB was now in a position where it had to sell its available-for-sale securities at an extreme discount, resulting in large losses to their equity through retained earnings. Since SVB had such large securities available-for-sale when compared to their equity, the blow to equity was substantial and brought them out of compliance on their solvency and liquidity ratios. The next morning runs on the bank accelerated and SVB's financial position continually deteriorated to the point where they had to cancel their equity offering after the stock plunged more than 60% after opening.

In short, SVB's collapse was solely due to risk management negligence with regard to the duration of deposits vs the duration of their available-for-sale securities, with respect to convexity. SVB knowingly was gambling with depositor funds, not hedging interest rate risk on their available-for-sale securities in a period where interest rates are being hiked at their fastest pace in history.

Credit Suisse

While the problem at SVB had to do with risk management negligence, Credit Suisse is another story. Credit Suisse has been an underperformer amongst banks for years, with continual losses and ongoing litigation. Over the last 6 years, CS has only turned a profit 3 of those years, with the last 2 years showing substantial losses totaling around ~$10 billion. Additionally, Credit Suisse can't seem to keep its name out of headlines appearing in Archegos Crash, money laundering, tax evasion, just to name a few.

When looking at CS, it seems obvious to me why when SVB along with regional banks started to crash, people ran to CS to withdraw their money. They have a history of volatile profitability with constant ongoing litigations/scandals, destroying the companies' reputation over time in the minds of depositors.

How First Republic Bank Differs

First Republic bank, in my mind, has been found guilty by association by the public and presents an oversold buying opportunity. First Republic Bank mainly differs from SVB and CS in two ways: risk management; and historical profitability.

Avail for Sale Sec to Equity

FRC does not have the same problem with regard to its available-for-sale securities.

First off, FRC maintains available-for-sale securities with higher yields than that of SVB, which would substantially decrease the potential loss on available-for-sale securities.

Secondly, FRC maintains a much larger equity position when compared to their available-for-sale securities. In the event that their available-for-sale securities would need to be sold to meet liquidity needs, their Equity would be able to manage the blow and still achieve its solvency and liquidity covenants.

Recent Backing of 11 Major U.S. Banks

Along with FRC's impressive risk management, FRC has generated profits over the last 6 years, with an impressive ~30% margins.

Additionally, FRC's clients' recent withdrawals of deposits have resulted in ~$30 billion of cash leaving the bank. Recently , 11 major U.S. banks came to the rescue by depositing ~$30 billion in cash back at FRC. This comes with no strings attached, is not a bailout, is not a loan, but rather a deposit from the big banks showing their sign of faith in First Republic Bank.

Conclusion

First Republic Bank is oversold and guilty by association by the wave of bank collapses going on today. FRC shows historical profitability, backed by 11 major U.S. Banks, and its risk management with regards to available-for-sale securities to equity. First Republic Bank poses a unique buying opportunity, where I believe it to be selling at a steep discount to intrinsic value.

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