JPMorgan Buys First Republic With Lessons To Consider From 2008

JPMorgan now holds the distinction of having acquired the first and second largest failed banks in U.S. history from the Federal Deposit Insurance Corporation.

The FDIC took over both banks before JPMorgan acquired them. The FDIC seized the largest institution — $309 billion (assets) subprime mortgage lender Washington Mutual (WaMu) — in September 2008 before JPMorgan bought it for $1.9 billion, according to the Washington Post.

On May 1, JPMorgan took San Francisco-based First Republic ($229 billion in assets) off the FDIC’s hands while booking a multibillion dollar accounting gain, paying $10.6 billion now, according to JPMorgan, and receiving $50 billion in five-year, fixed rate deal financing from the bank regulator, according to the New York Times.

Since peaking at $219 in early November 2021, First Republic stock lost most of its value before trading was halted on May 1.

JPMorgan CEO Jamie Dimon famously regretted buying Bear Stearns and WaMu. The banking giant paid $19 billion to settle regulatory disputes related to these deals. In 2015, Dimon wrote in a shareholder letter he would not buy Bear Stearns again and he overpaid for WaMu.

Will JPMorgan — whose shares rose about 3% in May 1 — have better luck with First Republic? Will more banks fail? Read on for thoughts on these questions and more.

JPMorgan Buys First Republic

JPMorgan just agreed to take on First Republic’s deposits and acquire its assets. The FDIC estimates that the risk-sharing agreement with JPMorgan will trim billions from its Deposit Insurance Fund.

The California Department of Financial Protection and Innovation took over First Republic on May 1 — appointing the FDIC as receiver following a failed bidding process to convince rival lenders to acquire the bank, according to CNBC.

JPMorgan will reopen First Republic Bank’s 84 offices in eight states as JPMorgan Chase bank branches. “All depositors of First Republic Bank will become depositors of JPMorgan Chase Bank, National Association, and will have full access to all of their deposits,” noted the FDIC.

JPMorgan will assume all of First Republic’s nearly $104 billion in deposits and buy most of its $229.1 billion in assets. The FDIC estimated that its DIF — which held $128.2 billion at the end of March — will suffer a $13 billion loss.

JPMorgan — which agreed to share gains and losses on single-family residential mortgages and commercial loans with the FDIC which will provide 80% loss coverage, the Journal noted — will report an immediate profit from the transaction, which the bank expects to exceed its future restructuring costs.

Specifically, Bloomberg reports JPMorgan will recognize a one-time gain of $2.6 billion tied to the transaction and forecasts it will incur $2 billion in related restructuring costs over the next 18 months, and expects the deal to add $500 million to its annual net income. JPMorgan is not assuming First Republic’s corporate debt or preferred stock.

Meanwhile, Dimon issued a statement praising the benefits of the deal for the FDIC and JPMorgan. The deal will minimize costs to the DIF, “modestly benefit our company overall, be accretive to shareholders, and help further advance our wealth strategy,” he said in a statement.

Why First Republic Failed

Following the collapse of Silicon Valley Bank, First Republic was the next most at risk bank. SVB’s failure cratered stock in First Republic — which had a strategy of issuing mortgages to wealthy individuals while requiring them to keep deposits there.

For example, in 2012, First Republic gave Facebook founder and CEO Mark Zuckerberg a $5.95 million mortgage with a starting rate of 1.05%, the Journal reported.

The rescue of First Republic began on March 16 when JPMorgan and 10 other banks deposited $30 billion there in a bid to stop a run on deposits like the one that felled SVB. 68% of First Republic’s December 2022 deposits exceeded $250,000 — hence they were uninsured by the FDIC.

By then First Republic’s stock had lost 88% of its peak value and I thought not enough had been done to save the bank and quell investors’ fear about the financial system.

The damage to First Republic became much clearer on April 24 in a first quarter earnings report indicating that clients withdrew $102 billion in deposits (58% of its December 2022 deposits) during this period. This forced the bank to borrow $92 billion, according to the Times — accounting for 72% of all recent borrowing from the Federal Reserve’s discount window, noted BCA Research.

In a conference call, First Republic CEO Michael Roffler abandoned the bank’s “previous financial guidance and opted not to take questions after an unusually brief conference call,” CNBC noted.

Like SVB, First Republic’s failure springs from a bad bet on interest rates. Both banks acted as though the Fed would not raise interest rates as much as it did. As the Washington Post reported, First Republic invested in long-term home mortgages and government securities when rates were low.

With the Fed Funds rate around 5%, First Republic was raising new money from the Fed and the Federal Home Loan Bank at rates some two percentage points higher than the 3% it earned on those long-term investments.

Bert Ely, a banking consultant in Alexandria, Va., told the Post, “Both of them essentially committed financial suicide by putting all these fixed-rate assets on their books and exposing themselves to a rising interest rate environment.”

First Republic has been bought and sold many times in the past. As Bloomberg reported, Merrill Lynch paid $1.8 billion to acquire First Republic in 2007 followed by Bank of America in 2009. In mid-2010, General Atlantic and Colony Capital
CLNY
scooped up First Republic for $1.86 billion and then took it public.

Will JPMorgan Have Better Luck With First Republic Than It Did With WaMu?

In 2015, Dimon said JPMorgan’s Bear Stearns and WaMu acquisitions had taught him “expensive lessons that I will not forget.”

In a 2015 shareholder letter, he wrote, “In the WaMu case, we thought we had robust indemnities from the FDIC and the WaMu receivership, but as part of our negotiations with the Department of Justice that led to our big mortgage settlement, we had to give those up. The WaMu deal might still make sense but at a much lower price to make up for the ongoing legal uncertainty.”

Based on the pop in JPMorgan’s stock, investors signaled optimism about the deal. This suggests they believe Dimon has learned his lesson and created iron clad limits to how much of First Republic’s asset and loan losses, and legal expenses JPMorgan will have to pay.

Are More Bank Failures On The Way?

While it is unclear whether more banks will fail, a March study found 186 of them shared traits that caused SVB to fail. That’s because these banks — which were not named in a paper by three economists — had a high level of uninsured deposits and considerable risk of loss to the value of their mortgages and long-term government securities due to rising interest rates.

Krishna Guha, head of the global policy and the central bank strategy team at Evercore
EVR
ISI does not expect a cascade of new bank failures. As he told the Times, since its was widely expected, the First Republic seizure “will not result in large spillovers in financial markets.”

Meanwhile, banks are still lending but they are tightening their credit standards in the wake of these big bank failures. “Lending is somewhat weaker than before the banking sector turmoil in March, but we haven’t seen a pure credit crunch,” Gregory Daco, chief economist at EY-Parthenon told the Post.

If borrowers can’t renew their loans or pay higher interest rates to secure them, loan defaults — which so far have not been the primary cause for 2023’s bank failures — could rise.

The challenge for investors is that nobody knows what will happen next to the value of First Republic’s assets and to the broader banking system. Perhaps JPMorgan should make considerable additions to its capital base to protect the global banking system from these unknown risks.