A number of things happened to First Republic Bank (NYSE:FRC) since I put out a counter call about two weeks ago to buy the shares of the community bank. FRC shares have since been whipped and banked has seen significant deposit outflows in the days following the banking failure of Silicon Valley Bank. A series of 8K revelations aimed to reassure investors that First Republic Bank has enough liquidity to manage increased deposit outflows, but investors have chosen to bet against the bank and they clearly expect the worst will happen. I continue to believe that First Republic Bank is not at risk of bankruptcy and that the common stock offers potentially highly risk-tolerant investors triple-digit return potential!
Risk management and asymmetric upside
To account for extraordinarily high levels of Due to volatility in the financial market, I have chosen to hold a very small position in First Republic Bank: FRC represents only about 1.05% of my investment portfolio which consists mainly of non-financial stocks. Given the asymmetric risk profile I see with brutal community banks, I believe investors could earn multiples of their investment here…as fears subside and confidence in the community banking sector returns. However, there is a chance that First Republic Bank will be shut down or forced to make a highly dilutive capital raise, which would likely seriously erode its remaining equity value. Therefore, investors should recognize that there is a possibility of losing the entire investment if things go south.
Liquidity update, estimated deposit outflows and 8K disclosures
Since my last call to consider FRC in the midst of the banking carnage, shares of First Republic have revalued about 60% lower. However, the bank made a number of 8K disclosures during the banking crisis that were intended to educate investors about the strategic actions taken by the community bank.
It all started with an 8K disclosure dated March 12, 2023, in which First Republic Bank announced that it had obtained additional liquidity from the Federal Reserve Bank and JPMorgan Chase & Co, bringing untapped liquidity to a massive $70 billion. Undoubtedly, the massive outflow of deposits forced the company to bolster its cash position.
Just days later, on March 16, 2023, First Republic Bank announced that eleven lenders had joined forces and deposited a total of $30 billion into the bank (8K source) to build confidence in First Republic Bank’s liquidity situation. This move also failed to appease investors, and the lender’s shares have continued to sell ever since.
In addition, First Republic Bank announced last week that a number of executives have agreed to cut their annual bonuses to zero for 2023, while others have forfeited all performance-based incentives unconditionally (Source). The latest 8K, dated March 22, 2023, was designed to rebuild confidence in the bank and align the interests of shareholders and executives. As equities fell further last week, it is safe to say that the latest measures have not yet had a positive effect on investor sentiment.
FRC’s corporate banking activities and recent deposit outflow news
What was First Republic Bank’s strength before the crisis, its banking business, has become its greatest weakness. The bank’s focus on risk banking – taking deposits from venture-backed companies and lending to them – has revealed an unforeseen vulnerability after Silicon Valley Bank closed its doors. The main problem with SVB was not deteriorating credit quality, but rather that the bank was forced to liquidate its bond portfolio at a significant loss to fund deposit outflows. Most banks now have unrealized investment losses, according to JP Morgan, including First Republic Bank…which isn’t a big deal, these assets don’t need to be sold. In addition, FRC’s capital position is not necessarily much worse than that of other community banks.
A possible solution to the crisis
As First Republic Bank has a significant focus on corporate clients – 63% of its deposits came from its venture banking operations which are at greater risk of exit due to the FDIC’s $250,000 insurance limit – the bank has a significant seen deposit outflows. The bank said in its 8K disclosure for March 16, 2023 that “daily deposit outflows have slowed significantly,” which is also what US officials have commented on recently. About 79% of First Republic Bank’s deposits were uninsured as of the end of fiscal year 2022. Prior to the crisis, First Republic Bank’s corporate deposits grew steadily and, according to the bank’s Q4’22 update, the bank also had exceptionally good credit quality .
However, I suspect that the bank will sell some of its loan portfolio to raise cash, which would be the best solution for First Republic Bank, and certainly preferable to a capital raise. The bank held $166.9 billion in loans at the end of the December quarter, most of which was backed by real estate. I see FRC selling some of its loans at a fair price to bigger banks to strengthen its balance sheet.
First Republic: Deposit losses and valuation impact
First Republic Bank is by far the worst performing community bank, largely due to its high rate (79%) of uninsured deposits and the need to raise $30 billion in additional deposits from other companies.
It’s impossible to know exactly how many deposits First Republic Bank has lost at this point, but the Wall Street Journal, citing insiders, said the bank lost about half of its deposit base, amounting to about $70 billion.
This means that FRC will also report a significant decline in book value in the first quarter of 2023. First Republic Bank reported a book value of $75.38 at the end of fiscal year 2022. Assuming a 50% decrease in book value, mainly due to deposit outflows and a shrinking balance sheet due to the financial sector crisis, FRC can report a BV around $37-38 per share at the end of the first quarter. Naturally, more aggressive deposit loss assumptions would translate into even higher book value declines. For example, a 60% drop in cash/deposits roughly implies a 60% drop in book value…which could push the Q1’23 BV closer to $30 per share. Since First Republic Bank’s shares are trading at $12.36, the valuation implies an 84% discount for BV. If deposits are indeed down 60%, the valuation may more accurately reflect a 59% discount to book value.
FRC offers by far the largest book value discount and therefore also has the highest risk perception. However, fear is clearly present here and investors may be overestimating the fall in FRC’s deposit base.
Risks at First Republic Bank
If the deposit outflow continues, the big banks might decide it’s a better idea to convert the $30 billion in deposits into equity, which would of course dilute shareholders greatly. First Republic Bank, in my opinion, has sufficient liquidity through the Bank Term Funding Program, the FED’s rebate window, and other banks, so I don’t believe the bank would be unable to fund incremental withdrawals of deposits. What would change me about FRC is if the company had to liquidate all or part of its bond portfolio and realize losses, or if the bank made a dilutive stock offering.
First Republic Bank remains a high-risk, high-potential stock in the community banking market, despite the fact that the stock has fallen dramatically since I took my first position more than a week ago. The reason I stand by my position here is that I consider it highly unlikely that the FED will allow fear and panic to spread in the financial market as it has learned the lessons of the 2008 financial crisis. This lesson is that it does not providing a liquidity backstop will ultimately lead to a crisis that is much bigger, much more difficult to contain and much more expensive than the initial, strong intervention. First Republic Bank has likely experienced very significant deposit outflows since I last covered the stock, but recent liquidity measures have proven to support the bank, while deposit outflows appear to have stabilized as of late. With the stock trading at an 84% discount to book value, I think investors still face a very attractive trading opportunity!
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