What Happened to First Republic Bank
In a nutshell, First Republic had a business model of providing ultra-low rate mortgages (including interest-only loans) to wealthy customers in exchange for them keeping deposits with the bank.
That business model doesn’t work as well when interest rates rise sharply. First Republic was taking large paper losses on its mortgage book as interest rates continued their rise, and the bank’s wealthy client base was demanding more interest to keep cash at the bank.
As the events of Silicon Valley Bank (SVB) and Signature Bank of New York unfolded in March, First Republic shares began to fall, as many deemed it SVB’s closest peer. However, First Republic and other regional banks held mostly steady amidst quiet trade into April after the shock of SVB.
Ultimately, though, First Republic’s earnings reported on April 24th were a dagger for the troubled institution, showing its deposits fell 40.8% in the first quarter.
The deposit outflows resulted in reports that the Biden administration was scrambling to find a solution, and the stock traded down to $8, nearly 95% below its early March share price.
First Republic Seized, Acquired
First Republic officially became the second-largest bank failure in American history on May 1, replacing the reigning silver medalist, Silicon Valley Bank.
First Republic stock was delisted on the New York Stock Exchange (NYSE) on Tuesday, May 2, days after the institution was seized by regulators and most of its assets were acquired by JPMorgan Chase & Co. for $10.6 billion.
The third failure of an American bank since March has investors rightfully scratching their heads.
Another Bank Failed. More On The Way?
“This part of the crisis is over,” said JPMorgan Chase & Co. CEO Jamie Dimon after his bank’s acquisition of First Republic.
However, on the same day – and the day before the May Federal Reserve interest rate announcement – shares of PacWest Bancorp and Western Alliance Bancorporation were in focus as they both fell sharply.
While nobody knows with certainty if more trouble lies ahead, it could make sense for certain investors to review their investment objectives or risk tolerance, depending on their time horizons and/or other factors. If you would like to discuss your strategies, please let me know. We will review your investments together.
Is This Like 2008?
No, it is not. It is fair to say that there is a regional banking crisis, but many differences exist between the present landscape and 2008.
In 2008, a wide variety of institutions were overleveraged and owned complex subprime mortgage-backed securities that turned out to be worth a lot less than they anticipated. These were bad loans.
At present, the situation is much different and is instead tied to rising interest rates.
Higher Rates, Mortgage Losses
Sure, First Republic could have managed its risk better, and it had the wrong business model in place before interest rates rose. But rising interest rates ultimately caused the steep losses in value and ultimate collapse that First Republic experienced.
Remember, bond prices and interest rates have an inverse relationship. When interest rates rise, bond values fall. And when you are a bank like First Republic or Silicon Valley Bank holding long-term debt (like mortgage bonds), the value of these assets deteriorates as interest rates rise.
When investors and depositors with deep pockets catch wind of a bank holding large amounts of deteriorating asset values that they may be forced to sell, they often pull their money out. This dynamic can create a bank run, and it did.
It is a fair statement that the recent turmoil in regional banks may not have occurred if the Fed did not raise rates so sharply or so quickly. But, on the flip side, inflation is plaguing Americans, which is why the Fed has hiked interest rates. In this case, it seems the solution to one problem has been the cause of another.
Fed Rate Hike
Speaking of rising rates, the Fed raised rates by 25 basis points on May 3, as widely expected. The move comes just days after First Republic’s demise and is reminiscent of the March rate hike following the collapse of Silicon Valley Bank and Signature Bank.
A notable omission of verbiage in the accompanying Fed statement hinted at a potential end to rate hikes.
FDIC Reforms On Table
As you may know, the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance for deposits up to $250,000 per depositor, per insured bank, for each account ownership category.
Well, that might be about to change. On Monday, May 1st, the FDIC proposed three new options to either change the coverage limit, have unlimited coverage, or offer targeted coverage for business payment accounts. All of the newly proposed options would require approval by Congress.
Remember, FDIC does not cover securities accounts; those are covered by SIPC. Here is how SIPC works.
Impact on Economy
So, how does a regional bank collapse (or multiple) affect the economy and lives of average Americans? For one, it concentrates deposits in larger banks as depositors move away from their regional counterparts.
Another pressing issue is accountability, a point of contention raised by Kevin O’Leary of Shark Tank fame, among others. O’Leary asserted that banks effectively become nationalized post-SVB and said that “you have zero risk, and that has consequences.”
His no-risk comment refers to the assertion that banks can take excessive risks, and should they not work out, the government will be standing by to rescue them. Does that inherently allow banks to take too much risk at the expense of the taxpayer or FDIC?
The thing is, the “risk” taken by First Republic was a relatively low one (lending large mortgages to wealthy borrowers with excellent credit) when measured by conventional methods in a normal market. Sharply rising interest rates quickly changed the risk profile of their business model.
Economic Perception
There are varying opinions on whether the current crisis is over or if there are more risks in the market. Even if the Fed is finished or close to the end of its rate hike cycle and pauses hikes for a while, other institutions with similar risks may face issues.
Let’s also point out here that bank failures create tightening credit markets and lending pullbacks. So, events like the First Republic collapse help to do the Fed’s job for them. Perhaps the recent bank failures and the potential for more of them have been priced into the market’s expectation of May being the final hike and a pausing Fed at the June Fed Meeting.
So, while the headlines of bank failures are ugly and some individuals have certainly been hurt by banking turmoil, it’s possible these failures will help the broader economy normalize more quickly than if they did not occur at all. Food for thought, but likely not much comfort for those negatively impacted.
Remaining Objective
We seem to be at a pivotal point for financial markets, amid rapidly rising interest rates, sticky inflation, regional banking system issues, debt ceiling woes, and other headwinds. Yet, the broadest measure of the U.S. economy, the S&P 500, has remained resilient thus far in 2023.
While banking indexes and ETFs like the $KRE and $KBE have fallen in 2023, large-cap technology has been supportive. The broader market has been quiet and has been having trouble breaking out in either direction recently.
Should the broader markets experience a pullback on the heels of banking woes, opportunities could arise for long-term investors with certain risk tolerances and investment time horizons.
On that note, let’s remember our long-term investing mission, regardless of the news. Here is a weekly chart of the S&P 500 from 2000 until now. Emotional investors that lost their resolve after the 2000 tech bubble, the 2008 financial crisis, and the 2020 pandemic have missed out on a U.S. economy that has moved from the bottom left corner to the top right corner of the chart. The data matters!
Best,
The Trademark Capital® Team
This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Trademark Capital’s investment strategies are built using quantitative, proprietary algorithms that are designed to identify and react to changing market conditions. However, investors should be aware that no investment strategy or risk management technique can guarantee returns or eliminate risk in any given market environment. As with all investments, Trademark Capital Management’s investment strategies are subject to risk and may lose money. The investment strategies presented are not appropriate for every investor and individual clients should review with their financial advisors the terms and conditions and risk involved with specific products or services. Due to our active risk management, our managed portfolios may underperform during bull markets. Past performance is no guarantee of future results.
