First Republic’s credit just got a downgrade to junk from S&P Global Ratings.
S&P’s analysts decked First Republic with a four-tier rating downgrade to BB+, the top tier of high yield, from A-, and gave it a negative outlook. Moody’s, which reportedly prompted last week’s speedy financing transaction that led to the run on Silicon Valley Bank, rates it four tiers above junk.
Obviously the past week’s mess — and now S&P’s downgrade — could make it pricier for First Republic to borrow. What isn’t entirely clear is whether the downgrade will affect the bank’s cost of accessing the Fed’s discount window.
Banks that are deemed by their regional Fed bank to be in “generally sound financial condition” can access the discount window at the cheaper primary rate, and those that don’t qualify for primary credit have to pay 50bp more, and usually have to borrow for shorter periods.
That matters because regulators have taken steps to make it easier for banks to obtain funding as regional banks face a crisis of confidence after a bank run caused Silicon Valley Bank’s failure.
First Republic’s downgrade is based in part on its concentrated depositor base:
We believe that First Republic’s deposit base is more concentrated than most large U.S. regional banks, which presents heightened funding risks in the current environment.
As of Dec. 31, 2022, First Republic had approximately $176.4 billion in total deposits, of which 63% were commercial. We believe the portion above the Federal Deposit Insurance Corp. insurance limit of $250,000 — about 68% of the total, or $119.5 billion — is most susceptible to withdrawal, despite the bank’s historically excellent depositor loyalty. According to the bank, its number of deposit accounts is about one-fifth that of the average U.S. bank with $100 billion to $250 billion in assets, which highlights its higher-than-average account sizes. Business deposits have an average account size of less than $500,000, while consumer deposits have an average account size of less than $200,000, as the company reported on March 10, 2023.
And its rising costs of wholesale funding, which presumably will become more expensive after this downgrade:
We expect earnings pressure to intensify given our expectation for reliance on wholesale borrowings, which are more costly than deposits.
First Republic’s total profitability is more weighted toward net interest income than most regional bank peers since its fee income (mostly fees related to wealth management) is less than 20% of total profit. The bank’s reported net interest margin in fourth-quarter 2022 contracted by 26 basis points from the prior quarter to 2.45%. Its fourth-quarter 2022 return on average assets and equity were modest at 0.74% and 10.1%, respectively.
The quality of its capital and assets seem fine!
We think these issues have arisen in the wake of the recent bank failures, particularly as it pertains to uninsured deposits, and not because of regulatory capital concerns or the bank’s excellent track record on asset quality.
The bank’s common equity Tier 1 risk-based capital ratio was 9.2% as of Dec. 31, 2022. Its ratio of tangible common equity to tangible assets — another solvency measure — was 6.4% (or 4.2% after factoring in losses on held-to-maturity securities). In February 2023, First Republic added $397 million of common equity, which we expect to bolster capital levels. The bank’s asset quality history has been excellent given the affluent nature of its customer base. That said, the large mortgage portfolio has fallen in fair value as interest rates increased and may provide less financial flexibility if rates remain higher for longer.
Unfortunately, though, the funding picture has gotten worse for regional and growthy banks since the run on SVB:
Lastly, we think First Republic’s business position is weaker following the events of the past week.
We believe the bank’s business position will suffer after the volatile swings in its stock price and heightened media attention surrounding deposit volatility. We think its business stability has weakened as market perceptions of its creditworthiness have declined.
Are “market perceptions of its creditworthiness” influenced by its ratings from firms like S&P, we wonder . . . anyway, here’s the full note. The stock is down nearly 17 per cent at pixel Wednesday.