Summary
First Republic Bank's current situation can be compared to a person in a vegetative state kept alive by a plug: in this case, the plug is the FED's loans.
The Fed has not yet been able to save First Republic.
Basically, in just three months, First Republic's deposit structure has completely changed.
Short-term borrowings have increased by $73.66 billion.
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Recently I wrote an article regarding the whole affair surrounding First Republic Bank $First Republic Bank(FRC)$ and why this bank was in clear trouble due to demerits not its own. That article was appreciated, and I thank you.
Anyway, toward the end I was saying that investing in this company before the release of the Q1 quarterly report was too risky since we could not know in detail the negative consequences of the bank run. Inevitably, that day came, and the stock immediately lost 20% in the after-market. The market certainly did not take the latest quarterly earnings report well, and my concern is that it may trigger another bank run after the situation appeared to have finally settled down.
To make a long story short, First Republic's current situation can be compared to a person in a vegetative state kept alive by a plug: in this case, the plug is the FED's loans.
The Three Main Problems That Emerge From This Q1 Report
Balance sheet in deep trouble
We all knew that the deposits were in great difficulty and the bank had become more indebted than ever before, but we could not know in detail the seriousness of the situation.
As a first aspect, I would like to show the table on Average Balances, Yields and Rates. It is important to understand how interest expenses and interest income have varied and consequently how they have affected the net interest margin. The comparisons will be made mainly with Q4 2022 rather than Q1 2022, as I prefer to highlight how much the situation has turned upside down in so few months.
FRC Q1 2023
First of all, let's focus on assets.
The average FRC balance of total interest-earning assets increased by $11.76 billion over Q4 2022 and its average yield increased by 15 basis points to 3.66%. This improving figure can be attributed to total loans, which not only increased by about $6 billion, but also saw an increase in average yield of 20 basis points in 3 months due to the increasingly demanding credit standards that banks are required to follow to lend money. In contrast, in terms of the average balance of total investment securities, there was an increase of $1.90 billion, but this resulted in a 29 basis point reduction in the average yield due to the reduction in the risk-free rate in recent weeks.
Overall, there has thus been an improvement. The average balance of interest-earning assets has increased and with it the average yield. There is a problem, however: what has increased is not only its yield, but also the cost sustained by the bank to finance its assets.
Both the cost of deposits and loans have increased. Let's start with the former.
FRC Q1 2023
The average balance of total interest-bearing deposits is almost unchanged from 3 months ago, however, interest expenses are now averaging 2.14%, 51 basis points higher. In this case, it is interesting to note that exactly one year ago, total interest-bearing deposits were generating an interest rate close to 0%, effectively making them almost noninterest-bearing. The bank financed itself at a negligible interest rate and everything proceeded without impediments; today, everything has changed after the Fed's severe monetary tightening.
Now we come to the sore point, lending.
FRC Q1 2023
The average balance of total borrowings increased by $25.40 billion in 3 months and with it the interest rate. From 2.79% in Q4 2022 to 4.33% in Q1 2023, a huge increase of 154 basis points, 258 over last year. First Republic was practically obligated to request as much liquidity as possible from the Fed to cope with the unexpected bank run after the SVB bankruptcy. It was a forced choice and will have negative or deleterious consequences at worst.
After borrowing so much and at such high rates, the average balance of total interest-bearing liabilities increased by 97 basis points in 3 months to 2.73%. As mentioned before, assets produce an average interest of 3.66%; with a cost of liabilities of 2.73%, the net interest spread is only 0.93%. This figure 3 months ago was 1.74%: in short, it has almost halved.
Therefore, the disproportionate increase in debt has weakened not only First Republic's balance sheet, but also its income statement. Even if this bank does not fail, it will have to struggle with much lower profit margins than in the past when it financed itself at rates close to 0%.
According to the latest words of CFO Neal Holland, First Republic is already beginning its balance sheet restructuring process and is committed to reducing expenses and short-term borrowing. The following changes are expected:
Significant reductions in executive compensation.
Shrinking corporate offices and reducing non-core projects and activities.
Reducing workforce by about 20-25% in the second quarter.
Personally, I doubt that any of this will change the fate of this company, but at least it is appreciable that efforts are being made to get out of this dire situation. The reason for my pessimism is because by now the bank no longer inspires confidence, so there is little that can be done. Banks are special businesses because its customers are also its lenders, so the moment the customer loses its trust in the bank, the bank also loses a lender. When deposits become scarce, banking stops, and continuing to borrow short-term funds at a high rate is only a temporary hedge, not a permanent one. Unfortunately, this is exactly what is happening with First Republic.
FRC Q1 2023
As can be seen from this image, in just 3 months total deposits have declined by $71.96 billion. This huge cash outflow was mainly due to uninsured deposits, which were responsible for 95.80% of this meltdown.
Basically, in just 3 months, First Republic's deposit structure completely changed. On Dec. 31, uninsured deposits were 67% of total deposits; today they account for only 48%. But there is more.
Of the $49.82 billion in uninsured deposits, $30 billion are the funds deposited by major U.S. banks to show confidence in First Republic's soundness. Without these funds, uninsured deposits would be only 27% of total deposits. At this point, if such a disaster has happened in 3 months, I see no reason why in the coming months/weeks the remaining $19.76 billion in uninsured deposits cannot continue to decline.
But how did First Republic cope with a deposit outflow of $71.96 billion? It simply did not, or rather, it did it by taking on short-term debt with the Fed.
FRC Q1 2023
In these 3 months, short-term borrowings have increased by $73.66 billion, and as we saw earlier in the average balance sheet table, the respective interest rates are anything but low. The latter, in fact, exceed the average yield produced by the assets. The bank's problem is not how it will survive now, but how it will repay this debt, assuming there isn't another bank run and the debt grows even more.
FRC Q1 2023
The fact that the bank meets all the minimum capital requirements imposed by the Basel Committee does not imply that it is in excellent health. The refinancing risk is huge, especially considering that the Fed will not reduce interest rates at least until inflation is no longer an issue. The pivot has not yet been reached, in fact the Fed Funds Rate is expected to rise by 25 basis points next May 3.
Finally, to conclude the picture regarding the balance sheet, this chart shows the origination of new loans.
FRC Q1 2023
With such high interest rates, it is far more complex for households and businesses to borrow money. So, all this makes it difficult for First Republic, or more generally for all banks, to create new interest-generating assets. Demand is declining and new loans are being originated less and less.
Fed Loans Have Not Resolved The Problems
The Fed's short-term loans and the introduction of the BTFP did not bring the desired results since First Republic slumped 20% immediately after the release of the quarterly report. It is clear that for the market the problems are far from resolved.
As explained in my previous article, until the underlying problem is solved rather than postponed, in time there will never be a reversal of the trend. First Republic did not need short-term liquidity to be returned at a high interest rate, but it did need to regain the trust of its previous depositors with thresholds above $250,000. These deposits needed to be preserved.
Raising even temporarily the threshold for deposit insurance might have been a way to counter this sentiment of distrust toward regional banks, but now I think the damage is done.
First Republic is becoming more and more a bank supported by Fed loans rather than by its customers' deposits. Clearly, this situation is not sustainable over the long term, and if there are no new customers ready to deposit their savings, this bank is short-lived. And that is precisely the problem. How can this bank attract new customers after all that is happening?
Beyond the fact that 3 months ago it was a great bank and did not deserve to be in this situation, I think it is also important to identify with the perspective of a customer who wants to deposit his/her savings. Why should he or she do so at First Republic? There is certainly no shortage of alternatives.
Reticent Management And Contagion Effect
If there was a time to boost shareholder confidence, it was during the conference call. Unfortunately, however, management decided not to answer questions.
This reticent attitude on the one hand can be understood, but on the other it raises quite a few concerns. Answering the questions could have made the situation even worse, but deciding not to answer could have worse effects. Doing so certainly does not gain more shareholder confidence. I would like to know your views on this aspect.
Finally, I would like to talk briefly about the contagion effect. The Fed is doing everything it can to save this bank because it knows that any failure could cause a domino effect within the financial system. Currently, the situation is far from good, so I wonder if the mild recession expected by the Fed at the end of 2023 might be more severe than expected. Inflation still remains a problem, and reducing interest rates to stimulate economic growth is not an option at the moment.
Final Thoughts
Personally, I am quite pessimistic about First Republic Bank's situation, which is why my rating is a strong sell. The balance sheet has been completely turned upside down, deposits replaced by onerous short-term loans, and the net interest spread has almost halved in just 3 months. Despite continued Fed support, I don't see how First Republic Bank can recover. Even if it does, to believe that the price per share will return close to the levels of 3 months ago is totally misplaced. The balance sheet will be restructured, as well as the earning capacity will be markedly different. In short, nothing will be the same as before for First Republic Bank.
Source: Seeking Alpha
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