Slow Death

Why First Republic Bank failed – and why now

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Traders know that emotions can be dangerous in investing. It’s easy to get attached to a stock that you own, thinking you know something special that others don’t and this can be especially damning when the stock goes into free fall and you have to make a decision about whether to hold on or to wait. When a stock loses more than 90% of its value, the entire world might think it’s time to cut losses and move on – but you might remember the example of Amazon or Microsoft which bounced back from the dead because:

It’s only a bubble if return prospects don’t improve after prices fall
– Morgan Housel

Sometimes that can cost shareholders dearly. It’s exactly what happened in the case of First Republic Bank over the last six weeks. When Silicon Valley Bank got into trouble, First Republic’s stock plummeted from $115 to $81 within two days even before SVB was seized by the FDIC. A week later, it was down to $12. In less than two weeks, First Republic stock had lost almost 90% of its value. And yet… The bank continued to function, and shareholders held on after the FDIC’s intervention hoping for a reversal in fortunes.

It took billions of dollars in withdrawals, an abysmal earnings report, and six more weeks of time before confidence in the bank dropped further and the FDIC seized it. JPMorgan acquired it a day later. To some it might seem like the writing on the wall was clear the moment SVB collapsed, but then, why did the FDIC not act earlier? Was there hope that First Republic could be saved? And why did they seize it now?

Let’s dive into why First Republic failed, why the FDIC waited to take action, what this means for other banks going forward – and most importantly, what it means for your money.

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The start

All of this started when Silicon Valley Bank collapsed. At the time, SVB was the second-largest regional bank to fail after Washington Mutual in 2008, and depositors thought if that could fail, then anything could go next. The reason SVB had failed also had some similarities with First Republic’s case: SVB had locked in a lot of its deposits in long-term treasuries, and when interest rates started going up, depositors started withdrawing funds at the worst possible time for SVB to liquidate its assets. This caused SVB to realize losses, which led to questions about its financial stability, which led to further panic, leading to a chain reaction.

While First Republic didn’t invest in Treasuries, they did have a similar client profile and they had lent a lot in mortgages. Mortgages are considered extremely safe, which is why it’s so hard to detect risk from unexpected quarters. In 2008, the market crashed due to poor verification and improper diversification, but this time around, the quality of the mortgages had nothing to do with the failure – Instead, the rate hikes made a strong business model unviable for First Republic in a very short period of time, and when SVB collapsed, all eyes turned toward First Republic.

The risk of collapse was not immediate. The Federal Reserve put some emergency measures in place to prevent other important banks from going down – like guaranteeing FDIC insurance for deposits of any size in the case of SVB, and offering other banks the opportunity to borrow money at par using their treasuries as collateral, at par value instead of market value. It seemed to work… for a while.

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All fine here

A lack of money was just one of First Republic’s problems. The main issue was that a large portion of their customer base was leaving after the fall of SVB, and there was a confidence crisis in First Republic because of its similar loan profile and client history which had a very similar nature. And in what might have been a killer blow, Jim Cramer called it a “Very Good Bank” (just kidding… or am I?).

To be fair, First Republic was on top of the crisis, trying to calm its clients by assuring them that it had “beyond a well-diversified deposit base including over $60 billion of available, unused borrowing capacity” – but once the focus shifted from the bank’s investments to its loans, it gave rise to new fears.

You see, for a retail customer, a loan is a debt i.e a liability, and savings are assets. But for banks, it’s the other way around. Deposits are their prime liability because customers have a claim on them at any time and loans are their assets – the performance of the loans determine the prospects of the bank. This is where First Republic had a major problem. Due to rate hikes, the market value of the assets (loans) they owned was considerably lower than what it was on their balance sheet. According to the Wall Street Journal, “their fair value was $26.9 billion less than their balance-sheet value”. First Republic issued and held substantial loans for wealthy clients at record-low interest rates, and now, those loans were worth significantly less if they had to sell them to raise capital in a hurry.

With more people withdrawing money, there was the risk that they would actually have to liquidate their deposits and realize a significant loss – which would accelerate the bank run further. So several larger banks put together a $30 Billion “rescue package” to keep First Republic afloat. The Federal Reserve’s Bailout clause that allowed banks to borrow against their treasury holdings was also in place. And yet, First Republic soon got a…

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Reality Check

On Monday, April 24th, First Republic reported that their deposits had declined by 40% in the first quarter – this was after taking the $30 billion rescue package into account. Without the stimulus, their deposits would have declined by more than 50%. This was much worse than expected. At the same time, their stock began to crash. Talks of a rescue deal began to surface, after their statement that the bank “was reviewing strategic options to help reshape its balance sheet.”

Now, let’s pause here for a moment – with more than 50% loss of deposits and a harsh interest rate environment, not to mention a stock that had crashed by 90%, you could argue that First Republic as a business was doomed. Yet, other banks were still trying to save it even if it meant a financial loss, and the FDIC waited for nearly a week before it seized the bank. Why were they trying to save the bank, and why was there a delay in letting it collapse?

I can think of two reasons:

1. Advisors to the bank were trying to “sell banks on the idea that letting First Republic fail would be even more expensive if it led to higher regulatory costs and fees.” There was also the risk that they would issue more stock to dilute shareholders as a way to raise additional capital.

2. The FDIC might have wanted to delay the inevitable (?) fall of First Republic to prevent a chain reaction of bank runs. Even after the collapse, the fear of contagion isn’t much and the situation seems contained. But without some sort of buffer period, panic can spread very fast as has happened before.

Either way, the situation was escalating fast…

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A little help

Because of this volatility, US Banking Regulators were considering downgrading the entire bank, which would have resulted in reduced borrowing capacity from the Federal Reserve, and further hurt their chances of successfully turning around. The Fed technically offered banks the ability to borrow at par against their assets – but by taking on the liabilities of a company the size of First Republic (which is the second largest bank failure in the US to date), their insurance corpus would be taking a hit and would affect their abilities to help other banks. So they were unwilling to intervene.

Eventually, the FDIC did take over the bank. This left shareholders in the lurch, effectively reducing the value of their holdings to zero, but the FDIC assured that all depositors’ funds were fully covered. In the meantime, they were hoping that another bank would step in and acquire the assets and liabilities of First Republic. This wasn’t an attractive deal, but for a large enough bank, it meant that they could take over billions of dollars in assets and if the financial crisis was weathered, they could come out stronger. More importantly, it would save some faith in the banking industry.

Finally, JPMorgan acquired First Republic. What’s interesting is that this would have been impossible in any other circumstance – The Riegle Neal act prohibits any bank from holding over 10% of all customer deposits in the US, and by taking over First Republic, JPMorgan would cross this mark. The Fed is overlooking this due to the “special circumstances,” considering the bigger picture. JPMorgan is now “too big to be to too big to fail”.

What do you feel about how the Fed handled the situation? Do you think the crisis is resolved now? Let me know below.

As part of the deal, JPMorgan will pay $10.6 Billion to the FDIC, for the acquisition of most of the assets – this includes $173 billion in loans and $30 billion in securities. They will be taking on the liabilities of $92 billion in deposits and $28 billion in FHLB advances. But as part of the deal, corporate debt and preferred stock were not assumed, and equity shareholders would probably get nothing on their shares. Also, the Fed will be getting about $80 billion worth of assets and taking a hit of $13 billion on the money it lent to First Republic.

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Why does this matter? Well, first of all, precedents are very important in the banking industry because so much of the industry is based on customer trust in institutions, and everyone is watching closely to see how the government and other banks handle the crisis. With First Republic closing down, the general sentiment is that the situation is contained for now, with JPMorgan CEO Jamie Dimon saying “This part of the crisis is over.” Regional banks stocks like PacWest and Western Alliance are still sliding though – so we have to see how this pans out.

As customers, this is a repetition of the message that the government continues to prioritize the safety of customer deposits and is doing all it can to stabilize the banking industry. On the other hand, with the Fed’s rate hike having adverse effects, the economy is slowing down, and ironically, the bad news might be good news – they might put a pause on rate hikes soon. So let’s wait and watch.

Stay safe, stay invested, and I’ll see you next time – Graham Stephan.

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