First Republic disaster averted?

Dan Bruzzo, CFA | March 17, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A whirlwind week for First Republic (FRC) has seen numerous potential options come to the table – among them an industry-led bailout, a merger, or an outright sale. Although the outcome remains uncertain, FRC bondholders appear positioned for a reasonably high recovery value across the various potential resolutions for the bank, with or without the prospect of an outright sale.

In the latest development, the bank announced that management is weighing options that would include a sale late Wednesday evening. The comments led to another roughly 36% drop in equity price in early trading on Thursday, before it was reported that JP Morgan Chase and Morgan Stanley were leading a consortium of lenders to “bolster” FRC. The banks eventually clarified that they would make $30 billion in deposits in the troubled bank. After several pauses in trading, FRC stock recovered and moved back into positive territory for the day, as the industry bailout option does seem to be getting more traction from investors. As for the prospect of a bank merger, the FRC franchise does still appear to be an attractive candidate for a larger competitor or even one of the big 6 money center banks looking to gain a foot hold in the high-end banking segment, but a sale may no longer be necessary to keep the bank out of receivership.

The San Francisco-based First Republic Bank (FRC: Baa1*-/BB+*-/BB*-) caters to high-net-worth individuals given the typical size of borrowers, the bank’s concierge level service to its account holders, and its list of high-profile customers. The bank has 89 branches located throughout northern and southern California. As of year-end 2022, the bank had $213 billion in total assets, $176 billion in total deposits and $166 billion in total loan and leases. The bulk of the loan portfolio (about 61%) is concentrated in residential real estate loans including home equity lines of credit. The remainder of the loan book includes multifamily (13%), commercial real estate (7%) and other non-real estate loans (10%). FRC boasts extremely conservative credit quality with extremely low levels of non-performing assets on its books. The loan/deposit mix was just under 95% as of year-end 2022, with reliance on wholesale funding at about 10%.

The failure of Westcoast lender Silicon Valley Bank (SIVB), and subsequent collapse of Signature Bank (SBNY) triggered panic among bank debt holders and equity holders of similar sized and positioned banks with California operating footprints. Among the names hardest hit in the aftermath in the regional bank sell-off by the markets was First Republic Bank. In addition to FRC’s Westcoast footprint, the bank’s higher concentration in large, uninsured depositors sparked concerns about potential deposit flight. The share price had been halted on volatility numerous times since late last week. The shares sold off approximately 80% from 03/08/23 until 03/16/23, while the two long-dated sub bank notes had mostly seen bonds in a roughly $60 dollar price context before quickly moving into the low-to-mid $70s on reports of the industry run bailout (FRC does not have a holding company, meaning the bonds issued are the obligations of the operating company).

Federal regulators had already demonstrated that they are willing to backstop deposits in excess of $250,000 at the banks placed in receivership that were previously unprotected by the FDIC. That effort to make uninsured depositors whole had initially only had a moderate impact of stemming further doubts about contagion risk within the sector, but now seems to be helping cool some of the immediate term risk among “at-risk” regional bank names. In addition to those measures, the Fed has communicated that the discount window is open and available to lenders looking for additional borrowing capacity. The Fed’s new Bank Term Funding Program (BTFP) offers one-year loans to banks that offer up high-quality securities as collateral. FRC accessed liquidity from the Federal Reserve and went a step further by securing access to additional financing from JP Morgan Chase, which when combined brought their total available liquidity to more than $70 billion. FRC is still yet to access the Fed’s BTFP, which could provide even more emergency short-term funding.

FRC bondholders appear positioned for a reasonably high recovery value in a worst-case scenario where the bank would be placed into receivership with over $8 billion in prospective asset value net of their reported unrealized losses. There is only a combined $800 million outstanding of subordinated unsecured debt in debt two issues (which again are issued out of the bank operating company). That compares with the considerably larger buffer provided by preferred securities, which have over $3.6 billion outstanding, and would likely be subject to substantially more severe markdowns ahead of the bank opco debt.

Moody’s placed the Baa1 rating of FRC on watch negative earlier this week, along with fellow Westcoast lenders Western Alliance (WAL), Intrust Financial (IFNC), UMB Financial (UMBF), and including the larger western regional banks Comerica (CMA) and Zions Bancorp (ZION). Among the rationale for the ratings actions were the banks’ higher levels of uninsured deposits, along with the potential unrealized losses in their securities portfolios relative to current capitalization levels. In the case of FRC, Moody’s estimates that unrealized losses as of year-end represent about 38% of tier 1 common equity. Meanwhile, the percentage of uninsured deposits was estimated to be about 67% as of last quarter with an average deposit size north of $200k, both at the high end of regional banking peers, though multiples short of SIVB or SBNY.

Moody’s methodology highlights the thin equity buffer that these banks have in place relative to potential mark-to-market losses, which in FRC’s case are reported to be roughly $4.7 billion in unrealized losses in its HTM securities holdings. When looking at the overall size of FRC’s investment securities relative to total assets, the bank does not appear to have nearly as onerous a position in its securities portfolio compared to SIVB. As of year-end 2022, FRC’s held-to-maturity (HTM) securities were reported at $28.4 billion or about 13% of total assets. Meanwhile, available-for-sale (AFS) securities were just $3.3 billion or 1.57% of total securities. To put that in context, SIVB’s HTM securities at year-end were up to $91.3 billion or 43% of total assets, while AFS securities were $26.1 billion making the combined securities holdings up to 55% of total assets at the bank.

S&P and Fitch both took a more direct approach, lowering the ratings on FRC to non-investment grade following the rating action from Moody’s. S&P took the senior rating to four notches to BB+ from A- and left the rating on watch negative, with the rating agency also citing the elevated risk of deposit outflows given the larger overall account sizes. Fitch lowered the rating by five notches to B from A- and also left the rating on watch negative. It remains to be seen how quickly if at all the rating agencies might reverse course and return to investment grade with various bailout options on the table.