First Republic Bank: Uncertainty Prevails

Shares of First Republic Bank (NYSE:FRC) have fallen victim to the debacle around the SVB Financial Group (SIVB). Besides the similarities, that of being a regional bank and having multiple technology names as its clients, investors likely remember that as recent as February the bank raised $350 million by selling 2.5 million shares at $143 per share. That capital raise was opportunistic, adding to capital ratios, not because of credit losses but to fund continued growth.

A Small Intro

Since its founding in 1985, the San Francisco-based bank has been consistently profitable as it believes heavily on intimate relationships as well as great underwriting quality, with net charge-offs consistently coming in below the industry averages. Despite this discipline, the company has seen very strong growth in recent years, quickly growing its asset base.

The Industry Challenges

Right now financial institutions are hurt by basically two developments, which are closely related. For starters is that banks face pressure on deposits, with high near term risk-free rates creating a real gap with the interest rates which banks are paying depositors, creating quite some pressure on the deposit base of these banks.

That is not necessarily a huge problem, but it is in case liquidity is strapped (as it the case now). The issue is that investments made by the banks are hurt by the same rate developments, certainly if invested into multi-year and fixed rate products, even in apparent safe products like long term Treasuries. While there is no issue if banks can hold these until maturity, deposit outflows can result in forced sales of such investments, and thus losses to be recognized.

2022 Results

If we zoom into the results for 2022 we see that the bank had $176 billion in deposits, mostly held by businesses but for nearly 40% funded by consumers as well. The company has few accounts which is great for efficiency and building relationships with clients, but it comes at a drawback in the sense that average client balances are quite high, and often exceed the FDIC insurance limit. Still carrying 60% of the deposit base in checking accounts, average cost ran at 99 basis points in the fourth quarter.

Zooming into the business line the company had $111 billion in deposits by year end 2022, marking very strong growth in recent years. The company has just $19 billion in business loans outstanding, of which more than half to private equity and venture capital, being quite a risk of course.

Despite the higher interest rates, following the most rapid increase by the FED in recent history, the higher interest rates are visible in the profit and loss account. Full year interest income rose from $4.4 billion in 2021 to $5.7 billion in 2022, with fourth quarter interest income rising to $1.7 billion. Borrowing costs rose from less than $300 million in 2021 to nearly $900 million in 2022, surpassing half a billion in the fourth quarter of 2022 as the company still posted operating earnings of $2.1 billion for the year.

The deposit base of $176 billion by year end actually rose by $20 billion on an annual basis and was up more than $4 billion from the third quarter. This is not necessarily the result of the very high interest paid, as the business is showing solid growth. It furthermore shows that if deposit rates increases from essentially one percent now to 2 percent, that increases the borrowing costs by $1.7 billion, essentially wiping out all the operating earnings of the business. Liquidity is running a bit tighter with the company ending 2022 with just over $4 billion in cash, down from nearly $13 billion in the year before.

The question is what happens if deposits flee, in the sense of how much liquidity there is in cash and equivalents, and how much earnings power is there to raise deposit rates to avoid depositors from leaving, as otherwise less liquid assets would need to be sold. The company has a $166 billion loan book, mostly tied to (residential) real estate, but even these loans will be underwater in case of higher interest rates.

The company furthermore has $31 billion in debt securities being available for sale, but mostly classified as held to maturity. Fortunately, many of these assets carry yields in excess of 3% already, indicating that some re-rating has already taken place, as the same applies to the loan book. The 10-K filing shows a $4.8 billion unrealized loss being recognized on the debt securities. Fortunately, the company has $17 billion in equity on a balance sheet which totals $212 billion, but then again this is not a credit issue but a more potential liquidity issue.

Concluding Thoughts

The truth is that I am concerned about the bank here, but that goes for many these days. While the risk appetite, growth and concentration is not near the same as SVG, similarities are seen here as well, with assets having five-folded over the past decade, albeit that the bank has great credit discipline.

The issue however relates to deposits and while the company has seen deposit growth and pays on average a percent, it only has room to increase these payments by about a percent before breaking even. This is a bit concerning as the company does not have much liquidity. The problem might also have to do with the deposit base. In general, there is a strong relationship between the bank and its clients but the fact that average balances are high (and thus surpass FDIC insurance limits) is what is a concern.

Important to realize is that this was a $100 stock pre-pandemic, hitting a high at $220 in the autumn of 2021 as shares traded lower to $120 in the autumn of last year. Shares recovered to $140 at the start of this year amidst too much optimism as shares fell from $120 at the start of the week to a low of $45 on Friday, before rebounding to $80, actually at par with the reported book value.

Given all of this, I find myself not needing to play the role of hero here. While the bank appears real quality in underwriting, questions can be asked on the exposure to real estate loans in the region. The reality is that while the deposit base seems good, average balances are high which makes it easier for depositors to move away deposits, as the company does not have much earnings power to raise deposits while maintaining profitability.

Moreover, without an official statement by the Treasury or FED, uncertainty will likely make it hard for the tougher brothers to attract and maintain deposits.

Unless the situation is addressed in a convincing manner, speculation will rule the day as the risk-reward simply is very asymmetric in these circumstances making me very cautious here. Despite the excellent long term growth of the bank and risk management, it seems that risk-management was mostly focused on credit losses, as liquidity is the name of the game here.

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