Regional lenders in the US will have to deal with higher borrowing costs after the failure of First Republic Bank underlined the risk of a corporate debt wipeout once regulators get involved.
JP Morgan acquired First Republic in a deal brokered by the US Federal Deposit Insurance Corp but did not take over First Republic’s bonds, leaving bondholders out of pocket.
Although First Republic only had two subordinated bonds totalling US$779m – both trading at one cent on the dollar in the secondary market – the deal struck by the FDIC could have the unintended effect of raising borrowing rates for other regional banks as they look to diversify funding, refinance near-term maturities and build capital in anticipation of stricter regulatory requirements.
Indeed, the situation facing First Republic bondholders could lead to investors demanding higher yields for regional bank paper, said analysts at fixed-income investor Western Asset Management in a note on Monday.
"The bottom line here is that this was a good outcome for the US banking system, JP Morgan and First Republic depositors, but a worst-case outcome for First Republic investors," the analysts wrote.
Trading in the secondary market showed investors were reluctant to hold regional bank paper, even for bonds coming due soon.
“It is definitely a struggle in the front end of the curve,” said Natalie Trevithick, head of investment-grade credit strategy at asset manager Payden & Rygel.
Comerica’s 3.70% senior notes maturing on July 31, for example, were trading at 95 cents on the dollar on Thursday, according to MarketAxess.
Although the Comerica bonds' value should return to par in three months, investors are factoring in the possibility that the entire value of their principal might disappear before then.
Bonds of other US regional lenders were also hit hard, with First Horizon's US$450m 3.55% senior notes due on May 26 trading at 98 cents on the dollar.
The paper losses were more pronounced in the Tennessee-based bank's longer-dated subordinated debt. Its US$450m 5.75% 2030 bonds were at 70 cents on the dollar on Thursday, down from 95 cents on Wednesday.
Issuance needs
Market participants had been expecting regional banks to step up their senior bond issuance this year, in part due to expectations that US regulators would expand the scope of loss-absorbing capital requirements to small and mid-sized lenders. Banks could also see the benefit of diversifying their funding sources amid concerns they could face pressure from deposit outflows.
“There will be increased need for term funding,” said a syndicate banker who deals with US regional banks. “Spreads are wide, so no one wants to be the first to go into the market. But at some point, the window will get better and spreads will improve.”
However, the widespread selling of regional bank bonds in the secondary market means issuers will have to pay up if they need financing soon, market participants said. And if regional lenders tap the bond market at elevated rates, the higher interest costs could put pressure on earnings and limit lenders' ability to grow their loan books.
“The issue is less about the safety of the unsecured deposits, and more about the ability of banks to finance themselves and how that will affect their profitability,” said Matthew Duch, chief investment officer of Channel Investment Partners.
Others expressed scepticism that higher debt costs would dent regional lenders' margins as those banks overwhelmingly rely on deposits for funding. “We’re talking about entities that are more than 90% funded by deposits,” said Jesse Rosenthal, head of US financials at CreditSights. “Even with a significant coupon, you’re talking about a few basis points of funding cost pressure.”
Regional lenders have other levers to pull to raise liquidity and are now likely to wait for a more opportune time to hit the market, said Trevithick. Banks can borrow from the Federal Reserve Bank Term Funding Program or take out cash advances from the Federal Home Loan Bank system.
“Given the high cost of financing, it’s prudent for them to wait for more stability,” she said.