Good morning. Credit Suisse is well on its way to becoming a UBS subsidiary, and this is good news for markets. Our colleagues at Due Diligence have the blow-by-blow. Less good is the fact that, to clinch a deal, regulators ordered Credit Suisse to zero out some junior bondholders, even as shareholders get about 80 cents in UBS stock per share. What unintended consequences will follow? We will write about this in the days to come, and meanwhile email us your thoughts: &

First Republic

It was very good news for the banking system globally that Credit Suisse got bought. Across the Atlantic, investors might ask if the best outcome is for the same thing to happen to First Republic. The $30bn in deposits contributed by a consortium of large banks last week, and liquidity support from the Fed, did not reassure shareholders. The stock fell by a third Friday and then, in after-hours trading, by another 15 per cent.

First Republic’s basic problem is analogous to Silicon Valley Bank’s, though not as severe. SVB’s large portfolio of mortgage-backed securities, bought when rates were low, saddled the bank with mark-to-market losses. Combined with rising funding costs, the bonds were also dragging the bank’s profit margin towards zero. First Republic has a similar problem, but with a portfolio of mortgage loans rather than mortgage-backed bonds.

Here’s the math. As of year-end, First Republic had $17.5bn in shareholder equity. It had unrealised losses on its bond portfolio of $5.3bn — better than SVB, where unrealised bond losses were the equivalent of all its equity. Alas, First Republic also has $93bn in low-yielding fixed-rate mortgage loans. A mark-to-market writedown of those loans of a bit over 13 per cent, for instance, combined with the bond losses, would be enough to leave the bank without any equity.

The bank’s year-end financial statements show a carrying value for the entire real estate lending portfolio of $137bn, and a fair value of $19bn less.

It is perfectly possible, under normal circumstances, for a bank with little or no mark-to-market equity to not only function, but have a lot of value, so long as it remains profitable. That should be a key strength of First Republic, because of its strong wealth management business. The bank had a billion dollars in fee revenues last year. But wealth management is a reputation-sensitive business. The investors have to come up with an estimate of how many wealth management clients are going to stay with the bank.

Furthermore, depending on how many First Republic depositors have departed, some of those deposits will probably have been replaced by more expensive wholesale funding, adding to the pressure on the bank’s profits. The Wall Street Journal has reported that the bank has lost $70bn in deposits, or 40 per cent of the total, citing “people familiar with the matter”. Credit agency downgrades over the weekend won’t help with this. Here is S&P analyst Nicholas Wetzel, in his downgrade:

The $30 billion in deposits that First Republic reported it will receive from 11 large U.S. banks should ease immediate liquidity pressures . . . Nonetheless, we do not view this deposit infusion — which has an initial maturity of 120 days — as a longer-term solution to the bank’s funding issues. In addition, we think attracting meaningful deposits will be difficult, constraining the bank’s business position.

First Republic tapped higher-cost secured funding extensively over the last week — likely, in our view, to fund deposit outflows.

Anyone who buys the bank will have to assume the mark-to-market losses, complicating any sale. According to a Reuters report on Sunday:

Some U.S. regional banks’ efforts to raise capital and allay fears about their health are running up against concerns from potential buyers and investors about looming losses in their assets, five sources with knowledge of the discussions said . . . 

The five sources, who work at or with major banks and private equity firms and examined such deals, told Reuters that they have decided not to participate for now for fear they could be hit with losses in the investment portfolios and loan books.

What would make up for a lack of book equity is franchise value — the profit stream from the wealth management business, relationships with customers, brand value and so on. The hard question is what is left for shareholders. Here is Wedbush analyst David Chiaverini:

We believe a sale of FRC to larger entity should be beneficial for the banking system as a whole, and should help ease contagion fears. However, given the fair value marks embedded in both its loan and securities portfolios, we find it difficult to come up with a realistic scenario where there’s residual value for FRC common equity holders . . . While the company has an exceptionally strong reputation and franchise value . . . we are doubtful that the valuation accorded to these factors would be enough to cover the tangible book value shortfall on a [fair value] basis.

It will be interesting to see where First Republic’s stock opens this morning. More importantly for markets generally is how other bank shares fare. We would not be surprised if there were few signs of contagion. If there are other regional bank balance sheets that have problems like First Republic’s, we don’t know what they are. Even PacWest, a smaller bank that has seen its shares fall almost as much as First Republic’s, does not have mark-to-market losses of the same magnitude.

We continue to think, as we have said since the start of the trouble, that US regional banks as a group are well capitalised and liquid, and think contagion will be contained. A sale of First Republic would make us more confident still.

Will the banking scare hurt growth?

A lot of folks are suddenly worried about US regional bank lending. Over several decades regional banks have become a vital source of credit, especially in commercial real estate, where they make up the vast majority of lending. Alex Scaggs, whose excellent regional-banks primer will publish later today on Alphaville, shows this chart from Dario Perkins of TS Lombard. “Small” below means banks with less than $250bn in assets, which will tend to be regional:

Layered on top of that secular trend is a cyclical one: regional bank lending has greased the wheels of small business formation since the pandemic. As Joseph Wang has pointed out, 2022 marked a credit boom, spurred by strong wage growth and light household debt loads. Lenders big and small opened the taps. Lending by credit unions, a subset of small banks, exploded last year:

This helped sustain another boom in the small business sector, which accounts for almost half the jobs in the US. Job openings at firms with fewer than 10 employees are at an all-time high, note Thomas Simons and Aneta Markowska at Jefferies. New businesses (which are usually small) are being formed like mad:

Of course, the flipside of small bank lending financing small business hiring is that inflation has roared. An important way contractionary monetary policy needs to work is by cutting off credit to small businesses, chiefly through regional lenders. This is happening. Starting in the third quarter of last year, the Fed’s senior loan officer survey showed banks getting much stricter about lending to small businesses:

The worry now is an overshoot — too much tightening of credit. Piling the effects of higher interest rates on top of liquidity stress among regional banks could lead to a vicious lending pullback, in effect a massive tightening of financial conditions. In a note published Friday, Adam Slater of Oxford Economics points out that banking crises — such as the US savings and loan crisis or the UK’s 1973 secondary banking crisis — reliably damage growth (while cutting inflation). He identifies four channels: payment system disruptions, lower output from financial services companies, negative wealth effects and tighter credit. Magnitudes vary but studies of past banking crises put the fall in GDP levels in the low-to-mid percentage point range.

But is this discussion premature? As Slater writes:

The historical evidence also shows that policy responses matter. In an ideal world, the authorities would step in early to prevent problems at one or a few banks from causing broader financial (and real economy) contagion…

So far, the signs are good with the Fed moving quickly to establish a new facility; the SNB stepping in to support Credit Suisse; and reassuring statements from the ECB. So, the most likely scenario is that central banks remain vigilant and provide liquidity to help the banking sector through this episode. That would mean a gradual easing of tensions as in the LDI pension episode in the UK late last year.

For how fast and spectacular the banking panic has been, the scale of the underlying problem remains fuzzy. Central banks, fresh off stemming the market panic of 2020, are busting out the crisis toolkit again, including yesterday’s announcement of daily dollar liquidity lines. Betting they will fail seems a losing proposition. (Ethan Wu)

One good read

The $1mn bitcoin marketing exercise.

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