The Breakdown - First Republic's Failure Shows the Limits of Fed Bank Programs

Episode Date: May 1, 2023

After an extended ordeal, beleaguered First Republic Bank has been seized and sold to JP Morgan Chase. NLW covers the build up, the specifics of the deal, and why the example of First Republic illustrates the limits of what the Fed can control. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW “The Breakdown” is written, produced and hosted by Nathaniel Whittemore aka NLW. Research is by Scott Hill. Editing is by Rob Mitchell and Kyle Barbour-Hoffman. Our theme music is “Countdown” by Neon Beach.

Part of the lesson here is that all of the Fed programs in the world can't fix structural impairments. They can only bridge liquidity during bank runs. The underlying assumption behind discount window and other liquidity provisions is that deposits eventually return. But if deposits don't return, the logic fails. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Monday, May 1st, and today we're talking about the last day of First Republic. Before we get into that, a quick note. If you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review.

Or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. And I do want to thank you guys. A number of you have left great reviews this week. Believe it or not, people actually read reviews and make decisions about what they're going to listen to next on the basis of them. So I really appreciate you guys taking the time to do that for me. But to today's show, on Friday, we discussed how First Republic Bank was a zombie. Well, friends, the undead have been put down. So heading into the weekend, chatter was plentiful, but solid information was sparse, regarding the resolution of First Republic Bank.

First Republic has been in the headlines for months. Their stock has lost 90% of its value this year, with a huge amount of that drop happening in the week following the shutdown of Silicon Valley Bank. Obviously, after SVB, investors looked everywhere for where they thought the next banking domino might come from, and specifically they were looking for these mark-to-market losses on long-term asset portfolios, right? They were looking to find other banks that might have the same sort of duration mismatch, an interest rate risk that ended up doing in SVB.

And First Republic was pretty high on the list of contenders. Now, First Republic, unlike signature, for example, was allowed to take advantage of federal liquidity programs like the bank term funding program, but it has still been, let's say, wobbly at best ever since. Now, all during last week, there were rumors that First Republic would be seized and sold by the FDIC. And yet on Friday, no announcement had been made to that effect, and even late on Sunday, no announcement had been made to that effect. A lot of the discussion during last week had

centered around the impossible position that government agencies had found themselves in. You'll remember that a consortium of 11 large banks had already provided a $30 billion liquidity injection in the form of a term deposit that would remain locked in place until July. That deposit was just meant to buy time for First Republic, which has now shed $100 billion in uninsured deposits over the last few months, with very few now remaining, other than the $30 billion provided by that bank consortium. Having already provided funds, that group was now in a position where they might need to bear a loss if the FDIC was required to seize First Republic and no additional deposit insurance was approved. And it kind of seemed like the Biden administration wasn't keen to come in and bailout First Republic

in quite the way that people were expecting. Indeed, there didn't appear to be a massive rush to bring the saga to a conclusion. Instead, it felt kind of like a game of chicken. Despite the collapse in share price, First Republic was in a position to meet withdrawals and operate, it was just structurally unable to recover as an independent entity. Last week and over the weekend, the FDIC appeared unwilling to place the bank into receivership and was instead rumored to be shopping around the bank's assets to potential buyers in an attempt to resolve the bank's failures without placing another black mark on their record.

This is, of course, understandable given that Silicon Valley Bank and Signature Bank were the second and third largest bank failures in American history. As of the end of March, First Republic was the 14th largest bank in the U.S., slightly larger than Silicon Valley Bank was at its peak. And of course, for an administration moving into election season, it would be much easier to swallow a headline describing the sale of First Republic, as opposed to yet another bank failure on the books. Gary Cohn, a former Goldman Sachs president who served as Donald Trump's top economic advisor, said that the FDIC, quote, would prefer to sell the bank in its entirety rather than in pieces. What would most likely happen is the FDIC will seize control

and then simultaneously resell the assets to the successful bidder. And indeed, late on Sunday, Bloomberg reported that talks between potential buyers had extended long into the night. Reportedly, J.P. Morgan Chase, PN.C. and Citizens Financial Group had all been asked to submit offers. Bank of America and U.S. Bank Corp had also been involved in the process, but elected not to bid on the failing bank. Now, of course, these conversations have been colored by that exact same game of chicken or staring contest that we described just a moment ago. The banks, of course, are more interested in bidding on First Republic after the FDIC seizes it, leaving the government holding the bag on any losses, while the FDIC seemed to be attempting to avoid taking an additional multibillion-dollar hit to its insurance fund during the sale process.

They also wanted to avoid the need to invoke the systemic risk exception to backstop uninsured deposits, given the broad anticipated response to that type of action. Now, another wrinkle in the negotiations was that regulations actually prevent J.P. Morgan and Bank of America from making any further acquisition. already having accumulated more than 10% of the nation's deposit base. Lumida Wealth's Ram Al-Alawalia tweeted yesterday, Why the First Republic Delay? My guess, U.S.T is debating whether to enforce the deposit cap rule

that prohibits acquisitions if new co-deposits equal over 10%. Choices, one, waive the rule and run auction, big banks get bigger. Two, enforce rule but take bigger hit to FDIC insurance fund. In short, to successfully bid, these too big-big-to-fail banks would require an exemption from regulators. Meanwhile, the Biden administration has been quite vocal about their concerns around consolidation of the banking industry, so allowing this exemption could be a bad look politically, even if it would have been the most pragmatic solution to the crisis in the short term.

There had also been rumors swirling that bidding from private equity consortiums had been disallowed, with regulators preferring to transfer First Republic to an entity that already had a banking license. For a little bit of historical precedent, in 2008, J.P. Morgan's CEO, Jamie Diamond, was in a similar position, acting as the private market savior for failed banks. J.P. Morgan acquired both Bear Stearns and later Washington Mutual, making them the biggest coast-to-coast bank. This caused no end of legal and regulatory headaches over the next decade, and Diamond is on records stating that, in retrospect, he would not have purchased Bear Stearns to avoid those issues. Some had been speculating that J.P. Morgan

was willing to acquire First Republic at a fair price, but were seeking to extract significant regulatory and legal concessions from the government in exchange for doing so. In an interview on Saturday, former U.S. Secretary of the Treasury Larry Summers spelled out the difficult position the government found itself in. The government needs to act, he said, in a way where the uninsured depositors get their money out in whole. Summer said that failing to do so, quote, runs a substantial risk of setting off a wave of further withdrawals from all but the largest of institutions. These things are like forest fires. It is much easier to prevent them than it is to contain them after they start to spread. Now, one of the people who has been watching this most closely from

the crypto sector is former Bitmex CEO Arthur Hayes. Over the weekend, Arthur wrote, How to Think About First Republic? It's very simple. Will the regulators actually solve the problem and stop the banking crisis? Or will they find a half-ass solution that solves this particular issue believes the broader system just as faked? Whether a group of too big-to-fail banks buys FRC at a sweet discount

or the FDIC takes it over, the question we need to ask is, do the regulators finally realize that either the Fed cuts rates to close the spread between deposit rates and RRP, or the bank term funding program accepts any bank loan as collateral? It seems like the Fed still wants to hike 25 basis points at its meeting this week. They still don't get it, or maybe they do when they're just hoping and praying the market is stupid. Doesn't matter either way, a rate hike almost guarantees another non-too-big-to-fail bank will bite the dust this week.

First Republic has a loan book full of jumbo mortgages made to rich people at low rates that are now worth way less after interest rates rose. The next bank to maybe fail this week, I think, will have a loan book full of illiquid large commercial real estate loans. I'll be looking through my sell-side research for a chart that shows the U.S. banks with the largest CRE portfolios. I will then take a hard look at the 50 to 75% OTM short-dated puts on these banks to be purchased after the Fed's meetings. Yatsi Bitcoin equals $1 million. Now, to translate Arthur a little bit, what he's talking about is that the bank term funding program, which was the solution offered by the Fed as part of the resolution of Silicon Valley Bank and Signature Bank, has specific types of loans that it will accept as collateral. The idea is that instead of these banks that are seeing

significant consumer deposits having to sell their hold-to-matured assets instead of holding them to maturity, and in so doing realizing a loss, and in realizing that loss creating more incentive for more people to get their money out, they can just borrow the book value of the loan from the Fed instead. It's meant to allow them to deal with their liquidity issues while actually holding those loans to maturity. What Arthur has been pointing out for a while now is that the bank term funding program doesn't necessarily accept all the types of loans out there as collateral. And because of that, there are some financial institutions, such as First Republic, which has a big commercial real estate loan book, as well as a large portfolio of non-conforming jumbo loans that were made

as part of its recruitment of its wealth management business that aren't eligible for that bank term funding program liquidity. Arthur's whole thesis has been that eventually the bank term funding program is going to have to accept basically any type of loan as collateral. And so he sees this as just the next step. Now, on the subject of uninsured deposits, Yenst Nordvig wrote, remarkably little discussion around whether uninsured deposits would take losses in a First Republic receivership situation. The debate was very hot around SVB, why is the debate missing now? Jim Bianco quote tweeted that and said, First Republic's April 24th quarterly earnings report collapsed the stock in three days and put it in this position. What did it say and why a potential

FDIC takeover comes with a big dilemma? The big stat from last week's earnings report was FRC lost 100 billion of deposits by March 31st. This left them with 70 billion in deposits. probably a lot less now. 30 billion of those remaining deposits are 120-day time deposits, a.k.a. Jumbo CDs, from 11 big banks. They have about 80 days left to maturity, so these deposits still exist at FRC. This was part of a rescue package led by JPM's Jamie Diamond in March. Now, the rescue package is the problem. In mid-March, Yellen gave assurances that all non-insured depositors would be covered in any future bank failure. So, if the FDIC guarantees all FRC depositors, they bail out these uninsured time deposits held by the 11 banks. Do this and Washington

loses it over yet another quote-unquote bailout of bankers. Now, don't bail out the uninsured depositors, who are also uninsured creditors, and most likely they take a loss. Yes, the 11 banks will lose, but so will any other uninsured depositor. The risk is high that someone does not get a paycheck next week because their business took a loss in FRC. If so, sit back and watch 41% of the U.S. deposit base that is not insured, mainly businesses with deposits greater than 250K, try and get their deposits out of their not too big to fail bank, and into one that is too big to fail. Chaos and banking because Yellen reneged about protecting uninsured depositors five weeks after her promise to protect them. So what is the solution? Some larger bank takes one for the team,

buys them, probably loses money, but all depositors are protected. Bankers remember, JPM took a giant loss on Bear Stearns in Wammu in 2008 the last time they took one for the team, so no one wants to do it. Yet JPM and PNC are bidding. Why? One can only imagine the arm twisting behind the scenes, especially since it was Diamond's idea to put $30 billion into FRC. Bafa has been invited to bid as well. Why? Because Dodd-Frank rules prohibit JPM from buying them and adding to the concentration of the banking industry. They need an exemption. Regulators need competitive bids to show JPM is the best offer to grant that exemption. Sinali Bacic, a global finance correspondent at Bloomberg, asked a similar question. She writes,

burning question, if the FDIC puts First Republic into receivership, what becomes the depositors, many of which are now the nation's big banks. Is there a systemic risk exemption here? Wall Street Journal's Nick Timoros responded. The White House press secretary strongly hinted the answer was yes when addressing questions around First Republic deposits on Thursday. Quote, we know what's in our tool belt. Quote, we have moved really quickly before. Quote, I could assure you that you'll see that again. And other policymakers have made clear that the systemic risk determination was about limiting contingent risks writ large and not about the interconnectedness of any one institution. Now, of course, with all of this, some in the crypto set were just frustrated that yet another big bank was seemingly on the verge of bailout when the crypto-focused bank seemed to have been let fail.

Ryan Selkis writes, did crypto kill First Republic 2? Or is D.C. going to recognize that there and the Fed's policies are to blame and not crypto? Maybe by bank number 10, things will change. So this was the state of things going into last night. But we all woke up this morning to discover that First Republic had indeed been sold to J.P. Morgan. regulator sees the bank for a pre-arranged sale, making this the second largest bank failure in U.S. history. J.P. Morgan will assume all of First Republic's $92 billion in remaining deposits, and buy most of its $203 billion in assets. Critically, the assumed deposits include the $30 billion in uninsured deposits placed in First Republic by a group of 11 banks, which J.P. Morgan is pledged to repay in full. As part of the agreement, the FDIC will share losses with J.P. Morgan, with the agency estimating that its insurance fund will shoulder around $13 billion in losses from

the deal. First Republic's 84 offices across eight states will reopen as branches of J.P. Morgan Chase for normal business as of this morning. Now, a notable feature of the deal was the loss sharing on the mortgages that were not eligible for the bank term funding program. In the transaction overview, they write, single-family residential mortgages 80% loss coverage for seven years, commercial loans including CRE, 80% loss coverage for five years. Kathleen Tyson writes, the term sheet fortifies JPM massively, bad deal for FDIC, especially the moral hazard now institutionalized to depositors. FDIC just insured 80% of CRE losses for five years. Jamie Diamond, meanwhile, said, our government invited us and others to step up, and we did. Our financial strength,

capabilities, and business model allowed us to develop a bid to execute the transaction in a way to minimize cost to the deposit insurance fund. Jonathan McCurney, a member of the FDIC board, said in a statement, we should acknowledge that bank failures are inevitable in a dynamic and innovative financial system. We should plan for those bank failures by focusing on strong capital requirements and an effective resolution framework as our best hope for eventually ending our country's bailout culture that privatizes gains while socializing losses. It strikes me as an extremely telling statement. The FDIC board member says that bank failures are inevitable, that we're going to see more,

and that where we should be focused as capital requirements and resolution frameworks, i.e. ways to deal with them. Now, I do think when we're looking at this, we have to be able to break apart the systemic issues from just the crises of any one bank. In other words, is it really problematic that a bank of First Republic's size failed? I think Sam Kala, the lead analyst at Swan Bitcoin, sums up what a lot of people are feeling. He writes, another one bites the dust. What's interesting about First Republic is it was given time and access to all the emergency lending facilities. It borrowed $63.5 billion through the Fed's discount window, 13.8 billion via the bank term funding program,

$28 billion from the federal home loan bank, and it still died. Now, part of the lesson here is that all of the Fed programs in the world can't fix structural impairments. They can only bridge liquidity during bank runs. The underlying assumption behind discount window and other liquidity provisions is that deposits eventually return. But if deposits don't return, the logic fails. Former central banker Kathleen Tyson again tweeted about this as well.

She writes, bank failure is getting bigger and more frequent. Money is leaving the U.S. financial system. Not sure how this plays out given excessive leverage and interconnectedness. M1 and M2 are both in decline. If bank deposits part of M1 were flowing into MMFs, part of M2, then M2 would not be contracting with M1. Money is leaving the system. Ugly. So friends, I think that is where we will keep our eyes trained for the next period, not just on individual banks, but also on the larger underlying issues that may be bigger than just this short-term liquidity crisis driven by interest rate risk and the hiking cycle. In any case, First Republic is no more. It is part of J.P. Morgan Chase, and we are on to the next one. Thanks for listening, as always, and until tomorrow,

be safe and take care of each other. Peace.