April 26, 2023 | Q: Who killed First Republic Bank (FRC)? A: Janet Yellen and Jerome Powell. Q: When did bankers and regulators first know they had a problem with QE and the banks? A: The middle of 2022.
Going back more than five years, The Institutional Risk Analyst described the existential market risk created by the Federal Open Market Committee’s massive purchases of securities. The recent movement of the bond market has reduced the visible unrealized losses on securities owned by banks, but the fundamental problem of mispricing of risk remains unresolved. Trillions of dollars worth of low-yielding assets are festering on the books of all US banks.
Ponder the remarkable idiocy of the Financial Stability Oversight Council, which just published a long list of recommendations for identifying risk among nonbank financial firms like Black Rock (BLK). The FSOC document never mentions the impact of quantitative easing or “QE” on financial institutions and markets. Chaired by Treasury Secretary and former Fed Chair Janet Yellen, one of the architects of the “go big” policy behind QE, the FSOC sees risk lurking in every corner but the one that actually matters.
It is clear today that the Fed's decision to start manipulating the bond market early in 2019 was a serious mistake, yet Fed Chairman Jerome Powell and Secretary Yellen are silent. The Treasury and Fed cannot admit fault for fear of bringing the whole house of cards crashing down, especially now that President Joe Biden has announced his reelection campaign.
How big is the risk created by Chair Yellen and her successor, Fed Chairman Powell, as a result of going “big” on QE in 2019 and then full throttle after March 2020? Let’s start with the data from the Securities Industry and Financial Markets Association (SIFMA), which shows that about $25 trillion in fixed income securities were issued in 2020-2021. If we adjust these securities by a conservative 12% haircut vs current pricing for say Fannie Mae 3% coupon MBS, you’re looking at $3 trillion in unrealized losses on COVID era securities.
The same price adjustment on trillions of dollars in whole loans priced during 2020-2021 gets you another couple of trillion in unrealized losses. We express the losses as a discount to par value, but the real problem for banks and other investors is the low levels of income coming from these COVID-era securities. Those Fannie Mae 3s issued in 2020 at 104 are trading at 89 today, but SOFR is just shy of 5% as are three-month T-bills.
Anyway we cut it, the US financial markets need to absorb about $5 trillion in securities losses to get clear of the cost of QE. This process of loss recognition must occur at the same time that banks and leveraged investors are forced to reprice their funding costs. As the process of repricing of liabilities moves forward, more banks will likely fail.
Looking at Q1 2022 to Q1 2023, for example, First Republic Bank (FRC) saw its funding costs go up 20x or twice as fast as JPMorgan (JPM) and other large banks. This violent change led to FRC’s near-failure in Q1 2023, leaving the institution today a function of support from other banks.
The enormous rate of change seen in FRC’s funding costs has to do with those risks that Secretary Yellen and other members of the FSOC don’t quite see. This is a qualitative risk that defies easy quantification and thus eludes “data dependent” regulators and economists. For example, FRC’s unrealized loss position over the past year was not large enough to warrant mention.
What was the chief risk facing FRC? Liquidity risk from the bank’s wealthy customers. The type of fully entitled, high-net-worth customers that were attracted by the “high touch” (and low profit) model of FRC had zero loyalty to the bank.
Compare the experience of Bank OZK (OZK), which we profiled in our last Premium Service comment, with FRC. OZK actually knows its customers, commercial and retail. When the bank raised deposit rates and asked their customers for support, the depositors of OZK responded and even grew deposits in Q1 2023. The customers of FRC, by comparison, took the money and ran.
Wealthy clientele such as the affluent individuals that banked at FRC have no loyalty to any particular financial advisor. First Republic was one of many advisers and service providers to their wealthy customers, people who find products like interest only mortgages attractive. These same products helped the bank to retain assets in normal times, but when liquidity risk arose the wealthy clients ran away. The Main Street business model of OZK was far more durable, it seems, than the asset gatherer model of FRC.
The structure of the FRC portfolio featured a high reliance on non-core funding, which was used to grow the bank’s loan book. Net-loans and leases at the end of 2022 equaled almost 100% of deposits vs 62% for Peer Group 1. When deposits started to leave the bank, the portfolio almost immediately ran into trouble as runoff forced asset sales. And it was the affluent and mobile nature of the FRC client base that enabled them to run.
Aside from the dependence upon non-core funding, FRC also suffered from poor profitability – even with $280 billion in client assets under management. The bank was generally below Peer Group 1 in terms of net income and the gross yield on its loans. A significant portion of the bank's income came from investment banking fees. Yet the bank’s non-interest, fee income as a percentage of average assets was actually below its smaller peers. FRC was more broker dealer than bank.
The bank had a pristine credit history, but the lack of basic profitability was telling through year-end 2022. FRC had an efficiency ratio in the 60s, in line with the larger banks but hardly challenged. The Q1 2023 earnings reported by FRC basically shows a bank that has failed in all but name, with almost $100 billion in non-deposit funding holding up the $200 billion asset bank.
During the trading day yesterday, FRC indicated that it was looking at strategic alternatives, including the possible sale of $100 billion in assets – likely whole real estate loans. But given the slow pace of asset sales by BLK for the FDIC, getting a bid for a $100 billion block of whole loans is unlikely – especially if those assets are underwater. FRC had a 3.24% gross yield on its loan book at year 2022 end vs over 4% for its larger bank peers.
The fact is that FRC and its assets may not be attractive unless the FDIC first takes over the crippled bank to cleanse the assets of any contingent liabilities. In the event, FDIC would likely retain the legacy 2020-2021 loan portfolio in the Receivership as it did with the securities book of Silicon Valley Bank. FDIC will then sell the bank’s asset management business, the deposits and selected assets, and the bank charter. FRC is a unitary bank with two valuable bank charters.
Optimists who believe that the bank can be salvaged need to know that the business model will be very different in a new First Republic Bank. A banking business that is stable and profitable must start with a Main Street focus, which includes traditional business and consumer business lines. The days of running an investment advisory business for high net worth clients, with a jumbo mortgage business alongside, from inside an under-performing bank are probably at an end.
But the more significant point may be that as the Fed drains trillions of dollars out of the system, it will necessarily force losses on 2020-2021 era securities. These losses could easily stretch into the hundreds of billions or even trillions of dollars, and may force the sale or failure of a number of banks along the way. The US banking sector, which stands in first loss position behind the Federal Deposit Insurance Corp and in front of the Treasury, may be forced to pick up the bill for QE.
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