by Jason Norris, CFA
Principal, Equity Research and Portfolio Management
“How do you go bankrupt? Two ways. Gradually, then suddenly.” -Ernest Hemingway
As of this writing, there are expectations that First Republic Bank may not survive the weekend. However, we believe that First Republic’s issues are not systemic across the industry. Unlike 2008, these issues with First Republic, as they were with Silicon Valley Bank, are not credit related. Rather, it was the issues that were part of their business model, which played out as Hemingway stated in “The Sun Also Rises.”
Generally speaking, these banks made a big push to attract high-net worth individuals and corporate depositors. While by itself, this is not a bad thing, it resulted in a lot of large loans made at very low interest rates. Readers will recall that the U.S. was in a state of historically low interest rates post the global financial crisis of 2008 until the Federal Reserve started increasing rates one year ago. Coupled with lending at very low rates, these banks used deposits to invest in government bonds, and since rates were very low, a lot of these investments were in long duration bonds in an attempt to pick up additional yield. This perfect storm hit last year when the Federal Reserve began raising rates. Higher rates resulted in some loans going “under water” as well as decreasing the value of the bond investments on the balance sheet. The chart below highlights the decline in government bonds over the last several years as the Federal Reserve raised rates.
In the last year, government bonds fell 10% as the Fed raised rates. This resulted in billions of dollars in losses on bank balance sheets.
Because banks have to meet certain capital requirements, additional cash was needed. As word spread, depositors, especially large ones (whose deposits were technically not insured by the FDIC insurance), began pulling their funds. The majority of First Republic’s deposits were above the $250,000 FDIC insured threshold, therefore resulted in larger withdrawals. First Republic disclosed this week that they saw $100 billion dollars of deposits leave the bank in the first quarter. What could possibly come next is if a white knight comes in to provide capital or acquire the bank or if the FDIC will take it into receivership.
However, as we have stated in the past, we do not believe this is systemic across the banking industry. What will be a headwind for banks is profitability. As banks work to keep depositors, they will have to increase deposit rates, which, in turn, will pressure margins. While we have investments in the banking sector, our focus has been on institutions with a diverse business model. Even with this overhang and with First Republic’s stock down 43% on Friday, the rest of the regional bank stocks rallied over 2%.
April Surprise
We wrapped up the busiest earnings week for the quarter and results continue to come in ahead of estimates. With over 60% of the S&P 500 companies reporting, three-quarters of them have beaten estimates by an average of 7%. At this rate, earnings for the first quarter look to be down 2%. This is exceeding initial estimates as the economy is holding up better than some pundits expected.
Takeaways for the Week:
Stocks finished the week slightly higher as earnings provided a tailwind for performance
Market expectations are for the Federal Reserve to raise rates 0.25% next week for the last time this year