First Republic’s red flags

Good morning. I woke up early yesterday morning scared to look at my phone. I didn’t want to know what Credit Suisse’s share price was. Peeking through one eye, I saw it was up big, and went back to sleep. Waking up for the second time, I was relieved again to see the US bank indices up — with the solitary exception of First Republic, which was down big. This story just keeps coming. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

First Republic (and the banking system)

As of yesterday morning, First Republic’s shares had fallen 80 per cent in a little over a week. Even as other regional bank stocks recovered, First Republic kept dropping. But it turns out the bank has some important friends. From the bank’s mid-day press release:

First Republic Bank . . . today announced it will receive uninsured deposits totalling $30bn on March 16, 2023 from Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, PNC Bank, State Street, Truist and US Bank.

This seemed to help, a bit. The stock ended the day up 10 per cent. But it is worth noting that this was a $115 stock last week, and is now at $34. As of writing, the bank is down another 18 per cent in after-market trading (which is often thin and unrepresentative, but still). Why has the vote of confidence from the American banking all-stars not had a stronger, more lasting effect? I don’t know. Some possibilities:

• First Republic had $176bn in deposits at the end of the fourth quarter. If depositors have looked at the share price and taken fright, $30bn may not fill the hole?

• The 11 depositing banks have, between them, $1.2tn in equity and $14.1tn in assets. Did $30bn look a little halfhearted?

• First Republic declared that it had $34bn in cash in addition to the $30bn just deposited. At the same time, though, it said it had borrowed as much as $109bn from the Federal Reserve over the past week, and had also added $10bn in new loans from the Federal Home Loan Banks (more on that shortly). Again, how big a hole are we trying to fill here?

• The bank said insured deposits have been stable since March 8, when the trouble started. But it did not update the market on uninsured deposits, which were $119bn as of year-end, or 67 per cent of the total.

But who knows, really. Everyone is nervous. Stock prices do not need good reasons to go down.

A question that can be answered somewhat more substantively is: why did the stock market pick on First Republic in the first place? It did not have Silicon Valley Bank’s problems to anywhere near the degree that SVB did. Insured deposits were just 3 per cent of the total at SVB. Long bonds were 55 per cent of SVB’s assets, against 15 per cent at First Republic. The unrealised losses on those bonds, if realised, would not have put a deep dent in First Republic’s equity. So what’s up?

Part of the answer was obvious to everyone all along. First Republic, which is basically a bank for rich people, holds a ton of big home mortgages on its balance sheet — about half of its total assets. Those have the same unpleasant characteristic as SVB’s securities: they have low yields (under 3 per cent) that will stay low when, as rates rise, the cost of First Republic’s deposits increases. This is not good.

But there is another, more important reason for the market punishment, which I was too thick to figure out until very recently. It has to do with a smallish item on the liability side of the balance sheet: loans, or “advances”, from the FHLBs. At year-end 2022, they totalled $14bn. A year earlier, they totalled just $3.7bn.

The reason this is relevant is the FHLBs are where banks go when, for whatever reason, they are in need of financing. The history of the 11 regional FHLBs is a topic in and of itself, but for our purposes what matters is that they make loans to their members — other banks — collateralised by government bonds and certain other assets. The FHLBs fund themselves, in turn, by issuing bonds that carry an implicit guarantee from the US government. As of December, the FHLBs had combined assets of $1.2tn. Crucially, if a bank they lend to fails, they are the first creditor in line, even ahead of the Federal Deposit Insurance Corporation.

At the direction of Aaron Klein of the Brookings Institution (you can read his outstanding work on the FHLBs here and here), I had a look at the third quarter filings for the San Francisco FHLB, to see who their biggest borrowers were. It’s an interesting group:

SVB number one; First Republic two, and Western Alliance, another of the market’s recent targets, comes in fourth. I then took Klein’s advice and looked at a New York Fed paper about the FHLBs, “The FHLB System: The Lender of Next-to-Last resort?” That paper contains a table of the banks that increased FHLB borrowing the most in the run-up to the great financial crisis, in 2007. Those who were around back then will look at the names, and shudder. Three of the top five no longer exist:

Boosting FHLB loans “is a classic red flag of a distressed institution ramping up its borrowing”, Klein says. We can’t say exactly why First Republic needed cash, but they needed it. Klein is surprised that SVB’s supervisors did not take note: “SVB failed a remedial test and was given an A” from its regulators, he says. Equity investors, it seems, were not so forgiving. When they saw the trouble at SVB, they might have sorted banks by increases in FHLB loans, and traded accordingly.

So, who is borrowing from the FHLBs now? A lot of banks, it seems. While one cannot follow FHLB borrowing in real time, they do disclose their own bond issuance, which is a proxy for borrowing levels. Jan Hatzius’ team at Goldman Sachs provides this chart, showing issuance leaping to over $80bn in just the past few days:

This absolutely does not mean that many other banks have the same kinds of problems that SVB and First Republic did. Instead, it likely means that all banks are getting cash where they can, either because the SVB mess scared them into prudence, or because depositors — simply out of blind fear — are pulling deposits. We are in a general, if so far mild, banking panic. And the FHLBs are not the only place that banks are going for cash. They borrowed $5bn from the Fed’s discount window in the week ending March 8. Last week, it was $152bn — more than in any week during the financial crisis:

To emphasise, this chart shows mass fear, not mass insolvency. But if depositors are pulling cash out of the banking system, where is it going? Into money market funds, partially. The FT reports that net inflows to money market funds hit $120bn in the past week, the highest since mid-2020. From the FT story:

The US financial system is extremely nervy right now. More weird things seem likely to happen.

One good read

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