Moody's flags potential mortgage impacts at First Republic

First Republic Bank's quality assessment as a servicer of prime residential mortgages had been put on review for potential downgrade as of Thursday night following deposit outflows and funding challenges.

On a scale of one to five on which lower numbers indicate strength, the bank has had a servicer assessment SQ2-minus. 

"The review for possible downgrade is due to a decline in First Republic's servicing stability component from Above Average to Average," the rating agency said in a press release. "The stability assessment incorporates First Republic Bank's long-term deposit rating, which was downgraded by Moody's from A1 to Baa3 on March 17, 2023. Moody's outlook on First Republic's long-term bank deposit rating remains under review."

The shift in deposit categorization marks a move from a low-end investment grade rating to a high-end speculative one.

First Republic's challenges stem from outflows of uninsured customer money partially offset by a short-term influx from a bank consortium, and risk exposures related to high-cost, short-term funding, according to a separate Moody's report on the long-term deposit rating change.

"Given the relatively short-term nature of most of the bank's new funding, First Republic still faces the eventual need to sell assets to repay these obligations. This could lead to the crystallization of the unrealized losses on its [available for sale] or [held to maturity] securities," Moody's noted.

"Its ability to sell residential mortgage loans, the other major asset on its balance sheet, without realizing losses that negatively affect capital is constrained," Moody's added. "Such a crystallization of losses, if it were to happen, would very materially weigh on the bank's profitability and capital."

The bank's challenges have some parallels with concerns affecting other financial institutions, but they vary in some ways.

For example, almost 68% of FRB's deposits were uninsured as of the fourth quarter of 2022, compared to nearly 94% at Silicon Valley Bank's, according to a report by S&P Global. It also is a bank account provider for several rated residential-mortgage-backed securities transactions in the small private-label market, according to S&P. 

And while holdings in the larger market for government-related MBS also play into First Republic's concerns, the bank was not listed among the top 20 depository investors in MBS like Silicon Valley Bank was.

Certain agency MBS that were backed by loans made when rates were lower and which suffered value declines as monetary policymakers raised rates last year have been contributing to banking challenges. The Federal Reserve has set up a facility to allow borrowing against such securities and some others. That facility allows the bonds to be valued at par, or their original value.

However, some concerns have emerged that limits to the type of collateral accepted into the facility could affect the extent to which it may be helpful to regional banks like First Republic.

This could contribute to larger fears about a potential credit crunch in the broader market should government interventions intended to prevent one fail to do enough to that end.

In First Republic's case, its main lending exposure is to the nonagency market for jumbo mortgages. It's a significant player in that niche, with single-family loans making up 43% of its $73.4 billion in originations during 2022. It had around $3.5 billion in servicing on the books at year-end.