First Republic Bank $FRC —part 2
*At the time of writing this article, $FRC is $23.03 during regular market hours, and $19.49 after hours.
I presume you have gone through the initial article; in this write-up, I’ll provide an update on the latest advancements since Thursday, March 16th, and then share my thoughts.
Summary:
In my view, the likelihood of current/future bank runs has significantly been reduced since posting the previous article, and our focus should now shift towards examining their balance sheet, specifically their mounting liabilities and interest payments.
The question with their liabilities is, first, can they pay off their interest payments, and at what cost? Second, would they still remain profitable? Third, can we estimate what their total assets & liabilities values look like?
Bank run risk reduced:
Per the 8-K filling on March 16th:
As of March 15, 2023, the Bank had a cash position of approximately $34 billion, not including the $30 billion of uninsured deposits from Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, PNC Bank, State Street, Truist, and U.S. Bank with an initial term of 120 days at market rates.
From March 10 to March 15, 2023, Bank borrowings from the Federal Reserve varied from $20 billion to $109 billion at an overnight rate of 4.75%.
Since close of business on March 9, 2023, the Bank has also increased short-term borrowings from the Federal Home Loan Bank by $10 billion at a rate of 5.09%.
Insured deposits from close of business on March 8, 2023 to close of business on March 15, 2023 have remained stable.
Daily deposit outflows have slowed considerably.
$FRC announced that the insured deposit has remained stable, hence we can assume that people acted somewhat rationally, in that they did not withdraw the money below the FDIC 250k limit. This aligns with the case 2 event, as mentioned in my part 1 article (https://victorinvesting.medium.com/first-republic-bank-frc-may-present-a-good-buying-opportunity-2af489f2aa91).
Furthermore, with reference to my previous article, I believed the credit facilities and short-term borrowing will cover the liquidity risk in the case of a bank run, i.e. FRC wouldn’t have to be forced to sell their AFS/HTM securities on the open market at a loss.
“Daily deposit outflows have slowed considerably” further indicates the reduced likelihood of continued/future bank runs.
Examining their balance sheet:
1. $30 Billion Deposit:
As of March 15, 2023, the Bank had a cash position of approximately $34 billion, not including the $30 billion of uninsured deposits from Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, PNC Bank, State Street, Truist, and U.S. Bank with an initial term of 120 days at market rates.
The interest on the $30 billion deposit will be paid out at a market rate. I presume this will be between 3.75–4.95% according to FRC’s CDs rates, which is partially in line with the FED’s interest rate.
If we assume the rate is 4.95%, this will entail an additional interest payment of 488 million for the next 120 days.
2. Borrowings from the Federal Reserve and the Federal Home Loan Bank (FHLB):
My view is that the additional liabilities are not a significant problem, what is significant however is their ability to pay down the interest. This is because the cash category of the asset will increase even though borrowing increased, hence producing a net-zero effect between the assets and liabilities. However, their interest expense will increase.
Hypothetically, let’s say Bank A has:
- $300 assets
- $100 liabilities ($100 deposits)
If they incur $100 more liabilities, their assets will also increase by $100 since they now have the equivalent amount of cash. Meanwhile, interest expenses will rise due to taking on new debt:
- $400 assets
- $200 liabilities ($100 deposits)
- +Interest Expense
Now let’s suppose depositors have withdrawn $100, then the assets will decrease to $300, and the liabilities will decrease to $100 (since deposit is a component of liabilities), hence it will look like this:
- $300 assets
- $100 liabilities ($0 deposits)
- +Interest Expense
It is evident that we have returned to our starting point, where the assets are worth $300 and the liabilities amount to $100. The only notable difference is that their borrowings, rather than deposits, now make up the liabilities component. Furthermore, the company incurs an additional expense in the form of interest payments.
Per their 2022 10-K:
Borrowing from the Federal Reserve:
From March 10 to March 15, 2023, Bank borrowings from the Federal Reserve varied from $20 billion to $109 billion at an overnight rate of 4.75%.
Just to be safe, let’s assume that the 109 billion in liabilities is new, as it is not mentioned in the 10-K. This implies an interest charge of 5.2 billion.
Borrowing from the FHLB:
Since close of business on March 9, 2023, the Bank has also increased short-term borrowings from the Federal Home Loan Bank by $10 billion at a rate of 5.09%.
As seen in their 2022 10-K, their previous short-term FHLB borrowing was 6.7 billion, at a rate of 4.4%. And since March 9th, they increased their borrowing by $10 billion. However, to account for the lack of info between December 31st and March 9th, I will assume they had a $20 billion net increase in short-term FHLB borrowing, to be on the safe end of things (margin of safety). I also assume the interest rate for all $20 billion loans is 5.09%.
This implies a new interest expense of 1 billion.
Adding up these interests:
This implies they will incur an interest expense of:
488 million +5.2 billion + 1 billion = 6.7 billion
Furthermore, to prepare for future FED rate rises, I will multiply the interest expense by 1.2 for that juicy margin of safety (obviously one might argue this is overdone, but personally, I like to be on the safe end).
Interest Expense = 6.7*1.2 = 8 billion
Purely from a valuation standpoint, one way to pay off their interest expenses is to sell their assets, in particular, their investment securities portfolio (i.e. AFS/HTM). This obviously implies they will encounter further losses, but what might this entail?
Scenario: Forced to sell 8 billion worth of assets:
AFS:
They would need to liquidate all of their AFS assets. And considering that they incurred an unrealised loss of -12.3% on 31st of Dec 2022, and now that the interest rate has risen another 0.25%, and possibly another 0.25% in the next Fed meeting, I will assume they incur a loss of -15.5% on their AFS assets to be safe.
This leaves them with 3.22 billion in proceeds, a net AFS assets loss of -3.8 billion, and a further 4.78 billion of interest to pay.
HTM:
As of December 31st, 2022, they suffered an unrealized loss of -17% on their HTM assets. Based on the subsequent rate increases, I would estimate their loss to be around -20.5%.
This leaves them with a net HTM assets loss of -6 billion to cover the 4.78 billion in interest expense. *The maths is (4.78/(1–0.205))
Pessimistic Valuation:
Hence, the total net decrease in assets is -3.8–6 = -9.8 billion
187m shares = common + preferred
Tangible Book Value = (212,639–195,193–218–9800)/187 = $39.72
Assume a tangible P/B Ratio of 1
Fair value = $39.72
Basis case:
If we chose not to multiply the interest expense by x1.2 earlier, then the interest expense would remain at -6.7 billion.
This would imply an AFS loss of -3.8 billion, and a further need to finance 3.48 billion of additional interest expense. Hence, an HFS loss of -4.38 billion (3.48/(1–0.205)). Resulting in a net decrease in assets of -8.18 billion.
Tangible Book Value = (212,639–195,193–218–8180)/187 = $48.4
Other scenarios:
They can choose to sell their AFS assets, and raise cash from selling equity instead.
For example, considering the Basis Case, if they choose to offer 50 shares at $20 per share (1 billion in proceeds), it might look something like this:
Tangible Book Value = (212,639–195,193–218–7180)/237 = $42.4
At the end of the day, this is all speculation.
Takeaway:
Rather than immediately selling AFS and HTM securities to increase liquidity, $FRC made the smart decision to borrow funds to cover any potential future deposit withdrawals. As a result, their losses are significantly lower as they will only need to sell a minimal amount of AFS and HTM securities compared to my assumption in my previous article https://victorinvesting.medium.com/first-republic-bank-frc-may-present-a-good-buying-opportunity-2af489f2aa91.
Additional Issues:
- Profitability Question, can they continue to be profitable, will they be forced to increase savings interest rates to attract/bring back customers
- How long are they expecting to borrow? My valuations assume interests are for one year only.
- What the private share offering entails, is it in warrants, preferred, or common stock?
Risk Factors:
- Rising Interest Rates
- Bank Runs
- Recession
- Housing Crisis
- Share Dilution
- Profitability
Disclaimer:
The information provided on this blog is for educational and informational purposes only and should not be considered financial or investment advice. The content is not tailored to any particular person’s financial situation, and the ideas expressed may not be suitable for everyone.
It’s important to conduct your due diligence and seek professional financial advice before making any investment decisions. Any investment involves risks, including the potential loss of principal, and past performance does not guarantee future results.
Disclosure:
The author of this blog has positions in the stocks mentioned and may purchase or sell these stocks at any time without notice. The author will not be held responsible for any losses or damages that may occur as a result of any investment decisions made based on the information provided on this blog.
