CONTRIBUTORS
Ivor Schucking
James J. So, CFA
What happened?
First Republic Bank, the 14th largest US bank, was put into Federal Deposit Insurance Corporation (FDIC) receivership this morning after a competitive bidding process over the weekend that resulted in JPMorgan (JPM) assuming all of the bank’s $92 billion in deposits and substantially all of its assets, $173 billion of loans and $30 billion of securities. The Federal Deposit Insurance Corporation (FDIC) chose JPM given that its bid was the lowest cost and most efficient option (per the FDIC’s assessment), at an estimated loss of $13 billion to the FDIC Insurance Fund1 (for comparison, the estimated cost of Silicon Valley Bank was $20 billion and Signature Bank’s cost was $2.5 billion).2 As part of the transaction, First Republic Bank 's 84 branches in eight states reopened as branches of JPM (Chase Bank) today, and all First Republic Bank depositors will become depositors of JPM with full access to their deposits. With three of the four biggest US bank failures in history having taken place so far in 2023, First Republic Bank is now the second-largest US bank failure after Washington Mutual (which JPM also took over back in 2008).3
JPM was able to customize an extremely attractive transaction with minimal downside risk and considerable upside in most probable scenarios. For example, JPM is not buying First Republic Bank equity nor assuming First Republic Bank's debt or preferreds, both of which are trading in the low single digits this morning. JPM is also protected from potential litigation with considerable support in terms of the following: (1) considerable loss sharing on the low-risk loan book, at 80% loss coverage for seven years on residential mortgages and five years for commercial real estate; (2) the FDIC will provide a new $50 billion, 5-year fixed-rate term financing and (3) favorable capital treatment of 25% risk-weighting for loans, given the FDIC loss-share agreements.4 JPM's stock is up roughly 3% on the announcement given the attractive deal economics alongside a complementary branch network and customer base, and meaningful wealth management assets.5
Market implications
We view JPM's First Republic Bank takeover as a positive outcome for the US banking system, JPM and First Republic Bank depositors. Systemic fears should decrease going forward as we believe the US banking system is healthy, and First Republic Bank will likely be the last major US bank to fail in this cycle. Silicon Valley, Signature Bank and First Republic Bank are clear examples of underregulated banks with high asset growth, large uninsured deposits, highly concentrated deposits/customers and large interest-rate risk mistakes (high unrealized losses on large held-to-maturity portfolios).
Regional bank earnings and business models will continue to be under stress in 2023, given higher regulation (e.g., liquidity and interest-rate risk), higher deposit costs, higher FDIC insurance fees, rising commercial real estate loan losses and increased staffing needed to comply with a more stringent regulatory framework, etc. The regional banking/confidence crisis will have longer-term effects on increased consolidation, more regulation, more rating downgrades and more differentiation. We also believe investors will require greater yield for regional banks and operating company bank bonds, given almost complete losses with First Republic and Signature Banks' operating company bonds.
Despite the aforementioned headwinds, deposit (out)flows in Q1 out of regional banks were manageable (with First Republic Bank as the outlier) and have stabilized overall. We think this is the beginning of the end of the banking system stresses caused by the rapid rate hikes over the past year and a half. Market reaction so far has been relatively muted, and bank stocks were mixed overall at the time of this writing, with some large money center bank equity up on the day while regional bank equity is down about 2%-3%. Spreads are a touch wider (+1 to +3 basis points) in both large money center banks and regional banks today, which is broadly in line with the rest of investment-grade credit markets. The bottom line here is that this was a good outcome for the US banking system, JPM and First Republic Bank depositors, but a worst-case outcome for First Republic Bank investors.
Definitions:
The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the U.S. federal government that preserves public confidence in the banking system by insuring deposits.
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
A spread is the difference in yield between two different types of fixed income securities with similar maturities.
Preferred securities (“preferreds”) are hybrid investments: fixed-income investments with equity-like features. They are mainly issued by large banks and insurance companies.
Endnotes
- Source: Sweet, K. “First Republic Bank seized, sold in fire sale to JPMorgan,” Associated Press, May 1, 2023.
- Source: Murdoch, S. and Mehnaz, Y. “U.S. backstops Silicon Valley Bank sale to First Citizens,” Reuters, March 27, 2023.
- Source: Sweet, K. “First Republic Bank seized, sold in fire sale to JPMorgan,” Associated Press, May 1, 2023.
- Source: “JPMorgan Chase acquires substantial majority of assets and assumes certain liabilities of First Republic Bank,” JP Morgan Chase & Co. As of May 1
- Source: Son, H, “JPMorgan Chase takes over First Republic after biggest U.S. bank failure since 2008,” CNBC, May 1, 2023.
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