Why First Republic, other banks got hurt after deposits surged to $5 trillion

By Joy Wiltermuth

Stocks are rallying since March, even after three of the four largest U.S. bank failures in history

Investors in U.S. stocks appear to be playing down the risks of sharply higher interest rates for the banking system and economy, despite the past two months ushering in three of the four largest bank failures in American history, according to the Wells Fargo Investment Institute.

Following its takeover by regulators, most of First Republic Bank's (FRC)assets were auctioned off early Monday to JP Morgan Chase & Co. (JPM), marking the third, large regional U.S. bank to fail since mid-March.

"Rising interest rates have strained many small and regional banks, and an echo of some additional failures in this group is possible," Paul Christopher, head of global investment strategy at the Wells Fargo institute, wrote in a Monday client note.

While Christopher doesn't expect a new, broader-based regional banking crisis to unfold, he does think investors in U.S. stocks may be underestimating the likely fallout for the U.S. economy from higher rates.

Here's why in a nutshell: "The dramatic 2020 decline in interest rates, to 15-year lows, encouraged a flood of bank deposits (see chart)," he said. Banks used the roughly $5 trillion influx in deposits to make low-coupon mortgages and to invest in long-term bonds.

The strategy has been coming back to bite. That's partly because the Federal Reserve's swift pace of rate increases created a new generation of higher yielding bonds, which threaten the value of older, lower-coupon assets created during the pandemic.

Higher yields available in Treasurys and other assets also have enticed many customers to move their deposits away from banks to earn income.

$5 trillion loss?

Low-coupon securities snapped up by banks, insurance companies and other asset managers during the pandemic might not pose a huge credit risk to investors, like the toxic subprime mortgages and related derivatives that flourished in the run-up to the 2008 global financial crisis.

Key Words: Charlie Munger says banks 'full of' bad loans on commercial property: report

But the pain of sharply higher rates still can pack a punch. When considering some $25 trillion in loans and securities were created during the low-rate years of 2020 and 2021, Whalen Global Advisors estimates that investors could be facing $5 trillion in losses tied to the huge swings in asset prices since the Fed began raising rates and reducing its balance sheet to fight inflation.

"As an illustration, suppose a home buyer is looking for a $2 million mortgage," Christopher at Wells wrote. "The bank that offers a below-market mortgage rate if the customer makes a large deposit at the bank is relying on low rates to continue. Once rates suddenly rise, however, this bank quickly may find its interest costs rising sharply -- just as its below-market-rate mortgages are less attractive to potential mortgage buyers."

The Fed boosted its short-term policy rate to a range of 4.75%-5% currently, from almost zero in February 2022, with another rate increase of 25 basis points expected on Wednesday. While still comparatively low, the (orange line) above chart also shows deposit costs increasing at banks since 2020.

Read: Fed expected to raise interest rates again this week -- perhaps for the last time this cycle

"Historically, the rise in interest rates slows the economy, and then the two forces become mutually reinforcing, first and most notably among those firms that relied too much on low interest rates," Christopher said.

"In our view, the more pressing problem for investors is that mutually reinforcing higher-for-longer interest rates and rapidly tightening credit put the economy on recession's front porch and moving ever closer to the threshold."

U.S. stocks ended lower Monday, after the S&P 500 index , Dow Jones Industrial Average and Nasdaq Composite Index booked back-to-back monthly gains in April.

Related: How First Republic ended up as the second-largest bank takeover in history after Washington Mutual

-Joy Wiltermuth

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05-01-23 1722ET

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