The US government seized First Republic Bank on Monday morning this week, wiping out equity
holders entirely and struck a deal to sell the bulk of the firms’ operations to JP
Morgan Chase.
TheFDIC and California regulators, announced this deal early on Monday, announcing that
they were simultaneously closing First Republic and selling off all $93.5 billion dollars
of its deposits and most of its assets to JPMorgan Chase who are paying the FDIC $10.6
billion dollars as part of the deal.
The deal wipes out First Republic investors and is estimated to cost the FDIC’s insurance
fund around $13 billion dollars.
The US Treasury department said that it was “encouraged” that First Republic depositors
had been protected and that costs to the FDIC’s deposit insurance fund had been minimized
by the deal with JPMorgan.
“These actions are going to make sure that the banking system is safe and sound,” US
president Joe Biden said on Monday as he stepped up calls for greater regulation of the sector.
“Critically, taxpayers are not the ones that are on the hook,” Biden said.
This is now the fourth US bank to fail in the last few months and the second-biggest
bank failure in US history.
In today’s video let’s look at some of the nuance of this deal and discuss the general
situation with US regional banks.
So, After Silicon Valley Bank and Signature Bank failed in March, people started looking
to First Republic as the next risky bank in the system.
Silicon Valley Bank and First Republic had a somewhat similar client base and somewhat
similar risks and problems such that investors and customers started to lump the two together.
First Republic Bank had just under 120 billion dollars in uninsured deposits as of year-end
2022 – and after the failure of Silicon Valley Bank – customers were obviously not
comfortable with having more than the insured sum on deposit at a regional bank.
Some of the biggest banks collected $30 billion dollars of their own money and deposited it
at First Republic Bank, with the goal of making up for the deposits that customers were pulling
(and signaling their faith in the business).
This seemed to work for about a day, but it didn't really stop the panic.
What First Republic had in common with Silicon Valley Bank, was a business model that was
unprepared for rising interest rates.
While Silicon Valley Bank’s problem was its investments in long dated low interest
rate bonds, First Republic’s issues were in its loan portfolio, where its model of
providing cheap mortgages to wealthy customers left it sitting on large losses when interest
rates went up.
On the funding side, customers started demanding higher interest rates to keep their money
at the bank – an issue I discussed in my recent video on Apple’s new savings product.
First Republic was more diversified (in terms of customer base) than Silicon Valley Bank
was, and overall, the bank was facing a few years of low earnings due to the low rates
they had locked in – but they might have survived had the bank not suffered a run on
its deposits.
Coming into April 24th First Republic was already in a bad spot, and their earnings
release that day showed that they had lost 100 billion dollars of customer deposits – more
than half of their total deposits had been withdrawn over the quarter.
There was a sense that this bank was increasingly at risk of being seized by regulators and
the stock began falling that week as news leaked out that the FDIC was actively seeking
buyers.
The FDIC allegedly invited half a dozen financial companies to review detailed information about
First Republic’s assets and deposits in the lead up to the eventual sale.
PNC allegedly made multiple bids, including one that would have involved selling some
of First Republic’s assets to Apollo - a private equity group and BlackRock - an asset
manager, according various news sources.
Bloomberg reports that JP Morgans bid “was more appealing to the FDIC than the competing
bids, which proposed either breaking up First Republic or would have required complex financial
arrangements to fund the $100 billion of mortgages.”
The FDIC’s brief takeover of the bank allowed the agency to enter into a five-year burden-sharing
arrangement with JPMorgan – which we will discuss shortly - on unrealized losses in
First Republic’s loan portfolio due to recent interest rate rises.
JPMorgan ended up acquiring $173 billion dollars in loans from First Republic, and approximately
$30bn of securities.
They are not assuming the failed banks corporate debt or preferred stock.
JPMorgan will pay the FDIC $10.6 billion in cash now, and another $50 billion in five
years time.
They will pay interest on that $50 billion dollars (but the interest rate has not been
disclosed – and it’s probably low).
What this means, is that the FDIC will get around $60.6 billion dollars to pay back the
Fed, plus roughly $15 billion in cash and roughly $4 billion of other assets that are
still left over at First Republic, for a total of around $80 billion dollars.
First Republic owes the Fed around $93 billion, meaning that the FDIC’s insurance fund will
take a hit of around $13 billion dollars.
The FDIC say that the $13 billion dollar loss “is an estimate and the final cost will
be determined when the FDIC terminates the receivership.”
Now before we dig into how the FDIC’s burden sharing deal with JP Morgan works, or the
possible aftershocks of the deal, let me quickly tell you about today’s video sponsor Morning
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Now, under normal circumstances JPMorgan, would not have been allowed to buy First Republic
for antitrust reasons.
US regulators can’t approve any deal that results in an institution holding more than
10 per cent of insured deposits in the United States.
And JPMorgan was already above this threshold before the deal.
But regulators were obliged to sell the bank to the party making the best offer.
JPMorgan allegedly “received a waiver from this regulation because it was by far the
best deal being offered”.
The decision to waive the rules was taken by the Office of the Comptroller of the Currency,
an independent bureau within the Treasury department that ensures lenders comply with
laws and regulations.
The deal wasn’t exactly a private sector deal either.
Jamie Dimon – the CEO of JP Morgan told the press that his firm had switched sides
from being an adviser to First Republic to being the buyer only after the government
asked the bank to “step up”.
On top of this, the final deal did include a $50 billion dollar line of credit for JPMorgan
as well as a loss-sharing agreement with the FDIC.
Now, that loss sharing agreement is one of the more interesting parts of this deal.
As the FDIC has agreed to bear 80% of the credit losses on First Republic’s mortgages
and commercial loans.
Now, as I mentioned earlier, First Republic’s loans had very good credit quality – so
this should not be a huge risk.
First Republic got itself in trouble by making low-interest mortgages to wealthy people,
who will most likely pay off their mortgages.
The issue wasn’t the credit risk, it was that the loans had fallen significantly in
value due to the rise in interest rates.
JPMorgan’s presentation even highlights the “high-quality portfolio” of loans
with a “strong credit profile” So why did they need a loss-sharing agreement with
the FDIC?
Well, a normal mortgage loan on the books of a bank like JP Morgan would require them
to fund the mortgages with around 7% equity capital.
When they get the FDIC to agree to a loss sharing agreement, it makes the loans safer
and means that they have to put up much less capital to earn the same return, this means
that their return on equity on these mortgages will be a lot higher.
The FDIC’s has two goals with this transaction.
The first goal is to get as much money as possible for First Republic, and the second
is to make sure that the banking system is well capitalized.
Selling the assets, a bit cheap, financing the deal with a $50 billion dollar loan and
allowing attractive regulatory treatment to carrying the mortgages means that the FDIC
is not just moving the problem to another bank – leaving the overall system as shaky
as before, it is instead reducing the risk in the banking system.
Had the FDIC not offered these sweeteners to the deal, JP Morgan would likely have offered
to pay less, and the FDIC would be announcing a bigger hit to its insurance fund than the
13 billion dollars it has announced.
JPMorgan announced that they will recognize a one-time $2.6 billion dollar gain on the
deal – so they definitely view this as a winner - but say that they expect to spend
$2bn on restructuring costs over the next 18 months.
JPMorgan announced to investors that the deal “accelerates” and “complements” its
wealth management strategy, which has focused on better-off rather than super-rich customers
and that some First Republic branches will be converted to wealth management centers
and that First Republic’s wealth management platform will become part of JPMorgan Advisors.
A number of well-known investors like David Hunt from PGIM speaking at the Milken Conference
on Monday argued that the turmoil in banking is not yet over.
Hunt argued that banks will be forced to comply with tougher rules that could crimp their
ability to lend just as the US economy is starting to feel the full force of the Federal
Reserve’s aggressive interest rate hikes.
Charlie Munger in an interview with the Financial Times warned of a brewing storm in the US
commercial property market, with American banks “full of” what he said were “bad
loans” as property prices fall.
The sale of First Republic has so far failed to prevent a further sell-off in other regional
bank stocks this week.
PacWest, which is seen as one of the weakest midsized regional banks, had its shares briefly
halted for volatility yesterday and was down almost 28% for the day.
Western Alliance – another midsize bank was down more than 15 per cent.
Both banks have drawn scrutiny because of their similarities to Silicon Valley Bank
and First Republic.
Mid-sized US banks are a subject of investor concern in general because US regulators have
said they plan to tighten supervision and regulatory requirements, which will probably
add costs and hit profits for these banks.
After the deal to acquire First Republic was announced on Monday Jamie Dimon said that
the rescue deal “pretty much resolves them all” but he prefaced his remarks with the
warning that “there may be another smaller one” to come.
If you found today’s video interesting, you should watch my video on the threat that
Apple Savings poses to banks next.
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Have a great day and talk to you again soon.