Stock of the week - First Republic Bank (16.03.2023)

Over the past week, shares of companies in the banking sector have seen a drastic discount. Particularly noteworthy was the sharp decline of First Republic (FRC.US), which lost nearly 70% of its value in just five trading sessions.... This bank has a strong foundation because it serves high net worth clients and has 0% net loan losses.

The situation in the banking sector

Silvergate, Silicon Valley and Signature, all major banks with exposure to cryptocurrencies, have been closed by regulators mainly due to large losses on the sale of their securities portfolio.

The regional banking sector is under considerable pressure. It all started last week with problems at a Silicon Valley bank. SVB Financial is the holding company of Silicon Valley, a bank specializing in financing technology start-ups. On March 8, SVB Financial announced the sale of its portfolio of securities (mainly government bonds) worth about $21 billion. This resulted in an after-tax loss of $1.8 billion in the first quarter of 2023.

Venture capitalists such as Founders Fund (Peter Thiel), Union Square, Tribe Capital and Founders Collective have advised their portfolio companies to place cash elsewhere. Y Combinator CEO Garry Tan also warned his network of start-ups that the solvency risk is real and that they too should reduce their exposure to the bank. The run on the bank, the forced sale of the bond portfolio and the recording of a loss on the deal was the nail in the coffin of SVB Bank.

The withdrawal of deposits is disastrous for the banks because they serve as collateral for loans. The Federal Deposit Insurance Corp. took over Silicon Valley Bank, and that went into receivership after SVB Financial was shut down by California regulators. The panic in bank stocks, however, may present an opportunity to buy shares of overvalued entities that have strong fundamentals. First Republic may be one of them. Here are 4 arguments worth considering.

Reason 1: Additional financing from JPMorgan and Federal Reserve

First Republic has fallen from a peak of $210 in November 2021 to $31 today. On Monday, shares were trading at $19 apiece. Investors are clearly panicking and wondering if First Republic is the next bank to be shut down by regulators.

First Republic is a bank with affluent and creditworthy customers, which also makes it somewhat risky due to its large uninsured amount of deposits. More than $140 billion of its deposits are in accounts that exceed the federal deposit insurance limit.

JPMorgan has guaranteed First Republic access to $70 billion in funds. The Federal Reserve also offered the bank additional funding capacity under its $25 billion Bank Term Funding Program in exchange for high-quality collateral such as Treasuries.

The additional liquidity injection of $70 billion is expected to cover more than 40% of the bank's total deposits of $176 billion.  

The problems at SVB Financial stemmed from large unrealized losses in its investment securities portfolio. First Republic showed interesting data on its investment securities and available-for-sale portfolio in its Q4 2022 results.

The combined investment securities portfolio (consisting of available-for-sale, held-to-maturity and equity securities, excluding any ACLs) accounted for 15% and 14% of total assets as of December 31, 2022 and 2021, respectively.

The weighted average duration of the available-for-sale portfolio was 4.4 and 3.9 years as of December 31, 2022 and 2021, respectively. The weighted average duration of the held-to-maturity portfolio was 10.8 and 10.6 years as of December 31, 2022 and 2021, respectively. 

Compared to SVB Financials' portfolio allocation of 57%, a total of 15% in investment securities is not much. This limits the potential for significant unrealized losses from falling bond prices.

Reason 2: Low exposure to unrealized losses as a % of total equity

Markets are in turmoil as investors flee the market for fear of a run on banks. Western Alliance Bancorporation is down 21%, PacWest is down 51%, and First Foundation is down 32%. These banks have the same risk factors as Silicon Valley Bank; they have a large exposure to unrealized losses in securities as a % of total capital.

One way to gain insight into the risk exposure of some regional banks is to divide negative AOCI by the bank's total equity less AOCI (by adding unrealized losses on AFS securities back to total equity). FactSet provided a list of 10 regional banks with similar risk factors as SVB Financial had.

The above list shows that First Republic did not have significant AOCI losses to total equity less AOCI. This is due to the fact that only 15% of its assets consist of a total portfolio of investment securities.

However, much depends on the current course of the Fed's monetary policy, so banks are likely still exposed to additional unrealized losses.

Reason 3: Impact of unrealized losses on capital ratios

JPMorgan explains the main reasons for Silicon Valley Bank's financial problems:

Deposits at U.S. banks grew by $5.4 trillion between Q4 2019 and Q1 2022, and due to weak loan demand, only ~15% was lent out; the rest was invested in securities or retained as cash. Banks refer to these securities as "available-for-sale" (AFS) or in hold-to-maturity (HTM) portfolios. SVB has relied heavily on HTM for its growing securities portfolio: as of 2019, its AFS book had grown from $14 billion to $27 billion, while its HTM book had grown from $14 billion to $99 billion. Selling HTM securities is complicated by the fact that it causes larger portions of the portfolio to be suddenly priced into the market, with the result that the bank could record a loss on the transaction.

JPMorgan has prepared an analysis of SVB Financial's impact on the banking system. It presented a chart showing the tier 1 common equity ratio adjusted for unrealized losses on securities.

The chart below clearly shows that SVB Financial's core tier 1 capital ratio, adjusted for unrealized losses, is around 0%.

First Republic continues to maintain a high core capital ratio of 6%, in line with JPMorgan's projections.

Reason 4: First Republic is a less risky bank

First Republic does not trade in exotic derivatives, does not invest in junk bonds, does not issue credit cards or car loans, and does not have negative amortization loans. Therefore, the bank's operational risk is lower than that of other banks.

Summary

Drastic declines in the regional banking sector are creating an opportunity to buy regional bank stocks cheaply, but only for investors who can handle high price volatility.

First Republic is a regional bank with affluent customers, and with credit write-downs at just 0%, its creditors appear creditworthy. However, since many deposits are uninsured, there is a risk that depositors could move money out of First Republic. JPMorgan has offered the bank $70 billion in liquidity, and the Fed has offered additional funds through its Bank Term Funding Program. FactSet also provides insight into the risk exposure of 10 regional banks. First Republic performed strongly in this analysis, with just 1.9% AOCI/TEC-AOCI.

Looking ahead, JPMorgan's analysis showed a dramatic result for SVB's Financial's CET1 capital ratio. First Republic's CET1 capital ratio is expected to be at a solid 6%. In addition, First Republic's risk management is favorable because the bank does not trade in exotic derivatives, does not invest in junk bonds, does not issue credit cards or car loans, and does not have negative amortization loans. Therefore, the bank's operational risk is lower than that of other banks. It is a very risky investment only for the most daring investors, but the potential profit can compensate for the risk.