The Breakdown - First Republic is a Zombie Bank

Episode Date: April 28, 2023

All week there has been a high-stakes game of chicken as the Fed, FHLB, FDIC, big banks who pumped $30B into First Republic and FRC itself all try to figure out if this thing can survive. Is it headed for FDIC receievership? Is this how the Biden Admin signals it won't bail out everyone?  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW “The Breakdown” is written, produced and hosted by Nathaniel Whittemore aka NLW. Research is by Scott Hill. Editing is by Rob Mitchell and Kyle Barbour-Hoffman. Our theme music is “Countdown” by Neon Beach.

It is dynamic, complex. It shows the interworking of these different actors in this power struggle. You've got First Republic themselves. You've got the big banks who helped capitalize them. You have other regional banks who are nervous about the example it might set. You've got the Fed, the FHLB, and the FDIC, all who have slightly different interests, even though they nominally represent the U.S. government. You've got Biden and Yellen who are dealing with election issues. And so it's a mess. Welcome back to The Breakdown with me, NLW.

It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Friday, April 28th, and today we are talking First Republic Bank and whether it is the next domino in the banking crisis. Before we get into that, a quick note. The breakdown newsletter is back. Every weekday morning, we are sending out what we're calling the first five, the five most interesting or important events in crypto, Bitcoin, macro. You can subscribe to that at Breakdown. down. B-Hive, which is B-E-E-H-I-I-V.com. And if you're enjoying the newsletter, please share it. And if you're enjoying this show, I would so appreciate it if you leave a rating or review.

But with that out of the way, let's get to today's show. Today is a macro show, because all week, people have been watching First Republic and asking whether it's the next banking domino. On Monday, First Republic disclosed more problems than anticipated in its quarterly report. Blockworks Jack Farley summed it up in a tweet. First Republic bank's deposits fell by 40% in 22 days. If not for the $30 billion rescue package from big banks, the decline would have been 57%. First Republic reports that their outflows have stabilized. FRC also expects to reduce headcount by 20 to 25%. Keep in mind, FRC is the most high profile and dramatic instance of deposit flight to occur at a bank

other than the banks that got taken over by the FDIC. So let's give a few more detail. First Republic was one of the banks that was subjected to a severe bank run in mid-March. U.S. depositors had become jittery about mid-sized regional banks and First Republic fit the bill. One of the ways that First Republic had their situation stabilized as compared to signature or SVB was that a consortium of megabanks provided them with a deposit of $30 billion to shore up their liquidity. The deposit was placed for an initial term of 120 days. First Republic's quarterly results showed that the bank's deposits had placed. plunged by 41% around $100 billion before accounting for the liquidity lifeline, which was a much

worse outflow than had been forecast. The bank added that it had cut as much as a quarter of its workforce, reduced outstanding loan balances, and curbed other non-essential activities. An analyst with Wedbush securities said, quote, First Republic is an idiosyncratic situation in terms of the magnitude of the stress that it's under. They predicted that the bank will face operating losses over the next few years. Following the release of the report, the stock price plunged more than 20% in aftermarket trading and is now down almost 90% since the beginning of the year. On a call with investors, CEO Mark Rothler said, quote, though we face challenges and uncertainties with the stabilization of our deposit base and the strength of our credit quality and capital position,

we continue to take steps to strengthen our business. The call featured no questions from investors. Now, this is not exactly a confidence-inspiring call, right? Certainly, not a confidence-inspiring statement. Now, trying to tamp down on negative speculation, First Republic stated that deposit outflows have now slowed, with the bank only losing 1.7% of deposits so far this month. Still, I think Adam Cochran sums up the general mood when he tweeted, Banking's stress is back on the menu. Now, there is plenty of doom and gloom out there when it comes to First Republic, so let's try to actually get a few of the more optimistic takes. analyst Brandon Carl wrote a long thread, which he basically said was an attempt to

give some information that could be positive given how much others were assuming the worst-case scenario. He wrote, uninsured deposits fell hard by nearly $100 billion, but are now stabilizing after banks added $30 billion. Only $19.8 billion now is uninsured and the flight risk is now much lower. Carl then goes through how the bank is trying to cut costs and increase deposits and writes that it's difficult but not impossible. He says, remember, you're trying to replace place government funding that's between 4 and 5%. You can offer incredibly competitive rates to pull people in. We don't see that happening yet. It's a tricky thing to manage as it involves paying more on your existing deposits in order to attract new deposits. Ram Alawalia also covered the call and

pointed out that while reports had been that their wealth management business was fleeing in terms of other firms poaching not just their customers but their team, the data doesn't necessarily seem to show that. Ram writes, the strength of FRC's wealth management franchise is evident. FRC's assets under management increased 7% to include $11 billion in net client inflows. Ramm also noted that there are lessons in terms of the shifting business model of banking, saying, zooming out, one of the lessons here is the resiliency of wealth management, capital light, SaaS-like revenue. It's the reason why Morgan Stanley, UBS, JPMorgan, are focused on pairing back on principal or market risk

and focused on growing wealth management. Recall J.P. Morgan's wealth management revenues are up 67% year over year, and City is investing to, quote-unquote, modernize wealth management. One of the questions in banking is what business models work and don't work. Wealth management works. Commercial banking with high uninsured deposits does not. Rem also identified, however, the same problem facing FRC that faced Silicon Valley Bank a few months ago. FRC, he writes, needs to generate liquidity.

The bank plans on shrinking its balance sheet, i.e. selling assets to pay down expensive funding. But how will the bank do that without incurring losses from selling securities or loans at a steep discount. FRC would ideally like to hold these assets to maturity. However, it needs committed funding, including for major competitors, and I doubt the funding matches the term of the loans. So this is where the week began, and like I said, those were about as optimistic takes as I could find. The much more average take was like this one from Wolf Richter, who wrote, First Republic discloses it's a zombie. Shares after jumping 12% during the day in anticipation of something wonderful, plunged 22% after hours now a hair from the March low. Jeff Snyder, the host of

Eurodollar University, writes, no one should be surprised that First Republic is back in the news. This thing isn't over by a long shot. What's different now is that the fallout, the credit squeeze, is already coming into view. Even the media can't ignore it. Also, when it came to that wealth management business, there were some very different takes. YouTube, Nobody Special writes, First Republic wasn't really a bank after all. It was a pig trough full of of interest-only mortgages for Wall Street execs in the Hamptons and Beverly Hills. Now they want to socialize the losses. So this is where we began the week. This is literally all just from Monday. Fast forward. On Tuesday, First Republic Bank was reported to be seeking a buyer for between

$50 and $100 billion worth of assets in an attempt to shore up its impaired books, according to anonymous Bloomberg sources. This is exactly what Ron was just talking about. Similar to Silicon Valley Bank, First Republic has a group of securities in its hold-to-mortality portfolio, which are trading significantly below their face value. A large institution which could afford to hold these assets to maturity could purchase these assets at a discount and realize their full value in due course. As an incentive to take this problem off their hands, First Republic would reportedly offer warrants or preferred equity to sweeten the deal according to one source. Now, at the same time, rumors were swirling that First Republic could be seized by the FDIC within

days if it couldn't take the necessary action to get its books in order. A large part of First Republic's business was offering jumbo mortgages to wealth management clients, with a large business and interest-only loans with no requirement to pay principal for up to a decade. During typical operations, those loans are not a problem, because wealth management clients rarely default. But these mortgages do not conform to government standards, so they are not eligible to be sold off to be packaged into agency mortgage-backed securities. That means that First Republic was facing a drawdown in deposits matched with a book filled with unsaleable illiquid assets. So yeah, the narrative started to shift pretty quickly.

Wall Street Silver tweeted on Tuesday, The only question remaining about First Republic Bank is whether or not they make it to Friday when banks are usually closed by the FDIC. Charles Gasparino, senior correspondent at Fox Business, said breaking. The big banks that capitalized First Republic increasingly view the institution as a zombie bank, unable to adequately compete, but not in immediate danger of collapse. Bank execs tell me if the latest rescue plan doesn't work, there is no choice but receivership. He followed that up.

Scoop. Bankers working with First Republic Bank say they expect eventual government receivership for the ailing bank after it exhausts private sector solutions such as asset sales and finding a buyer, both of which appear difficult. Officials at the big banks believe the feds were poised last week to take over FRC just before its earnings announcement crushed shares. Now, all of this led to people running the numbers about the FDIC in general. Custodia CEO Caitlin Long writes, update.

If the FRC story Gasparino broke this afternoon is true, then how will the consortium of big banks get back their 30 billion of uninsured deposits? She pointed out that the FDIC balance is $105.7 billion, compared to total insured deposits in the U.S. being $10.1 trillion. Arthur Hayes tweeted, when this bank bites the dust probably later this week, we will be closer to the market realizing the entire U.S. banking deposit base is de facto guaranteed by the USG. Massively inflationary, and that's why Bitcoin is rising on news that FRC is a dead bank walking.

Dossier newsletter publisher Jordan Shackdell says seems pretty obvious that none of these banks are getting new deposits, not just an FRB problem. When Yellen announced the selective backstop policy, it was curtains for every non-big bank in America. On Wednesday morning, CNBC reported that the government appeared to be unwilling to apply pressure to the large banks to formulate a rescue package, and as of Friday morning, the FDIC has still not intervened to seize First Republic, and no deal has been announced. Now, the regulator is in a difficult position. They could absolutely step in, sell the bank's assets, and backstop-only insured depositors. First Republic has around $50 billion in uninsured deposits, which includes the $30 billion deposited by the big four megabanks in March. If the FDIC allows uninsured depositors to lose out, then that reestablishes the understanding of how FDIC insurance works.

However, this presents two issues. First, it could reignite the nationwide bank run on small and medium-sized banks, given that large depositors can no longer assume that their money will be insured, and second, it would require the megabanks to take on a $30 billion loss. They could afford to do this, but allowing it to happen might mean that those large banks are no longer willing to step up and help resolve further bank failures in the future. Now, the other option, of course, is that the FDIC could step in and ensure all depositors, using the same systemic risk exception invoked during the failure of signature in Silicon Valley banks. As Hayes points out, this would more or less settle the open question of whether FDIC insurance is, in fact, unlimited, and imply a massive

payout to depositors that the banking crisis continues. The large banks are in a similarly difficult situation. While there have been rumors of a buyout floating around, no deal appears to be moving forward. With the megabanks already committed by depositing $30 billion in uninsured cash into First Republic, a buyout of assets for a premium could be seen as a better escape strategy than just allowing the bank to fail and to be seized by the FDIC. In that situation, the megabanks would likely not only lose their deposits, but also be liable for significantly increased FDIC insurance premiums moving forward. In his opinion piece on Thursday, Bloomberg's Matt Levine sketched out the problem. The fate of First Republic Bank, he says, has become a game of chicken between the U.S.

government and the lender's largest rivals, with both sides seeking to avoid steep losses and hoping the other will handle the troubled firm. Executives at five of the biggest banks, speaking on the condition that they not be named, dismiss the notion of once again banning together to prop up First Republic, especially when it could mean paving the way for investors or a competitor to scoop up the firm at a bargain price. Now, there is also a third path available to First Republic, potentially. That path is one in which no one rides to their rescue, and the bank simply muddles along, unprofitable, incapable of growth, but adequately capitalized to stop it from failing outright. It's risky, but not

impossible. Having lost a massive amount of its deposits, First Republic is now primarily funded by $105 billion in loans from the Fed and the federal home loan bank. Could that work, or long enough to allow it to ride out the problems? Maybe. In March, the Fed opened the bank term funding program for more or less this exact purpose. The facility allows banks to obtain loans from the Fed based on the full-face value of securities not accounting for market losses from interest rate increases. Part of First Republic's recovery plan was to shift their focus to writing eligible loans, which could be used as collateral at the Fed. So they might be able to slowly shore up their balance sheet over time, with help from the government agencies, avoiding the need to close down.

This would obviously be a very tenuous situation to leave the bank in, especially when it's being funded in part by 30 billion in deposits from the megabanks that are eligible to be withdrawn in July. Brendan Carlegan writes a really interesting thread about everything happening here. He says, the game theory around First Republic, the FDIC, the banks, and the White House is a bit crazy. When you walk through it, today's announcements from the FDIC and the U.S. government makes sense and may be an attempt to get the banks to recapitalize FRC. To begin, Wedbush had estimated that First Republic's tangible book value, if marked fully to market, would be negative $73 a share. If correct, the $13.5 billion capital whole is what creates an issue for any prospective buyer. In March, a bank consortium deposited $30 billion in uninsured deposits for an initial term of 120 days. This mitigates liquidity issues for First Republic.

As of April 21, 2023, they had $45.1 billion of cash equivalents and unused available borrowing capacity. This is where it gets interesting. If at the end of 120 days, the banks chose not to roll over their deposits, First Republic would pledge assets to the FHLB and Fed to tap additional borrowing. The collateralization is a key fact. In the event of receivership, the Fed and the FHLB can, to my knowledge, sees the collateral against the loans. This leaves fewer assets for the FDIC to sell, which would translate through to the FDIC carrying more losses. So if you're the FDIC, you threaten to downgrade the scoring condition so as to limit borrowing from the Fed and FHLB. Now in the event of the receivership, the banks lose up to $30 billion because they are unsecured. The FDIC gets away rather unscathed.

The banks don't want to take on the losses. Remember, there is an estimated $13.5 billion capital whole. With the FDIC setting them up to lose, the banks want the U.S. government to subsidize the loans, which is not what Biden and Yellen want into elections. So the government leaks that they are currently unwilling to intervene on First Republic as a clear signal to the banks. As the banks, you have now two options. See who blinks first or act. If you wait and the government blinks, then you may get your deposits back or a better funding deal on asset purchases. If they don't blink, you're back to losing up to $30 billion. And in either case, you've upset the hand that feeds you. This potentially forces the hands of the banks to play ball.

The proposal appears to be something like, one, buy assets for more than their worth, two, get warrants potentially becoming the main shareholder. Three, protect your $30 billion. dollars. The net effect is that you recapitalize some of the $13.5 billion, weighed out the losses on the assets, which eventually will be made good, and try to profit from upside on the warrants, which certainly sounds better than losing up to $30 billion. So guys, that is where First Republic is. It is dynamic, complex, it shows the interworkings of these different actors in this power struggle. You've got First Republic themselves. You've got the big banks who helped capitalize them. You have other regional banks who are nervous about the example it might set. You've got the Fed,

the FHLB and the FDIC, all who have slightly different interests, even though they nominally represent the U.S. government. You've got Biden and Yellen who are dealing with election issues. And so it's a mess. Now, I'm recording this around noon on Friday Eastern Time, and nothing has happened yet. Will something happen later today? We'll have to see. Until tomorrow, guys, be safe and take care of each other. Peace.