First Republic’s dilemma

Good morning. On a day when a bunch of huge, important companies reported results for the three months to the end of March — Microsoft, Alphabet, PepsiCo, UPS, McDonald’s — it was the news from First Republic, a bank with a market value of just a few billion dollars, that dominated the headlines. The squeaky wheel gets the grease, and boy oh boy is First Republic squeaky. Let us know what else has your attention: robert.armstrong@ft.com and ethan.wu@ft.com.

First Republic

There is a rueful Wall Street joke that goes like this: what is a stock that falls 90 per cent? It’s a stock that falls 80 per cent — and then gets cut in half. The gag is that measuring declines with percentages obscures just how painful those declines can be.

Yesterday, First Republic illustrated the point. The stock had already lost 86 per cent of its value following the collapse of Silicon Valley Bank in early March. SVB taught everyone how dangerous the combination of uninsured deposits and low-yielding long-duration assets can be, a combination that First Republic has in spades. The bank reported first-quarter results on Monday night, and Tuesday the stock got cut in half. Regulators and financiers are prepping for a rescue.

On the surface, the shocking thing was the loss of deposits. At $104bn, they were down $72bn from December, and that includes the $30bn in emergency deposits a consortium of 11 banks contributed last month. The bank remains solvent because it was able to replace the lost deposits with borrowing. But the real problem is that the new borrowing is so expensive that First Republic may no longer be able to make a profit.

First Republic was profitable in the first quarter. It had net interest income (what it earned on its assets less what it paid on its liabilities) of $935mn, for a net interest margin of 1.77 per cent, which is not disastrous. But the bank only had its new, expensive funding in place for the final few weeks of the quarter. If you take its balance sheet levels as of March 31, and apply the new funding costs for a full three months, the picture is very different. Assuming stable returns on the loans and other assets, net interest income falls (on my maths) to something like $260mn for next quarter. Assume that non-interest income and expenses also stay constant, and First Republic makes a quarterly pre-tax loss of more than $300mn, or about $1.3bn a year.

That’s a lot of assumptions, so I called veteran bank analyst Charles Peabody of Portales Partners. He confirmed I was thinking about it the right way. His own, more detailed analysis renders a slightly wider annualised pre-tax loss estimate of $1.5bn.

Unless First Republic can bring down the cost of its liabilities or increase the yield on its assets, it can’t make money. And the only way it can realistically do this is by selling its low-yielding assets and using the proceeds to pay down the high-cost funding. Hence yesterday’s Bloomberg report that it is hoping to sell $50bn-$100bn of assets, about a third of the total.

The tricky thing, as we have discussed before, is that selling the problematic assets — the long-duration loans and securities — would crystallise large losses that First Republic has not yet had to bring on to its balance sheet. At the end of the fourth quarter, First Republic reported that its mortgage loan and bond portfolios had a market value $27bn lower than their balance sheet carrying value. That gap will have tightened somewhat now, as rates have fallen some. But it may not be enough to matter. As of the end of March, First Republic only had equity of $18bn. Any sale will have to be handled very carefully indeed.

The good news is that First Republic’s problems do not seem to be sparking contagion in the rest of the banking system. Shares in other banks considered to have some degree of asset-liability mismatch (Western Alliance, Zions et al) only saw their shares wobble a little bit yesterday. PacWest, which had been the focus of worry, reported after the close and told of deposit inflows in recent weeks. The stock rallied strongly in late trading. In general, regional bank earnings have been OK.

But all is not completely well, as Peabody pointed out to me. First Republic disclosed that as of the end of the quarter it had borrowed $63bn from the Federal Reserve discount window and another $14bn under the Fed’s new Bank Term Funding Program. As of March 31, however, loans outstanding from those two emergency funding facilities were $88bn and $64bn, respectively. That implied that other banks have borrowed about $70bn from these facilities since SVB failed:

Remember, this is expensive funding: 5 per cent at the window, 4.9 per cent for term funding. So some bank or banks out there really need the money. And notice that the amounts outstanding in the facilities increased a little bit in the last reported week (which ended last Wednesday). This story may not be quite over yet.

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