We all knew something was happening over the weekend with First Republic Bank. What we didn't know was whether it would be dissolved or bought out by another bank. It turns out that JP Morgan Chase, PNC, and Citizens bank were bidding to buy the bank, and JP Morgan Chase came out on top. This article will explain what was happening that precipitated the deal, what the deal looked like and who is left holding what at the end of the day. A brief accounting tutorial is included to better understand both the situation and the deal.

The Back Story

 First Republic Bank was founded by the son of a community banker in 1985. Its business model was basically to lure high net worth customers by offering them advantageous interest rates on mortgages and other loans (in exchange for holding their deposits.) Here is how that strategy played out for them.

• Affluent customers keep balances well over the $250,000 FDIC insurance cap. In fact, the average single-family mortgage holder had $685,000. A full 68% of their deposits were uninsured.
• 22% of loans were made to schools and non-profits.
• The mortgages/loans made were pretty secure in terms of default risk, but interest rate risk was high. As the Fed raised interest rates, the value of these loans dropped which impeded selling them to raise capital. Furthermore, half of their loan book was comprised of single-family mortgages, which are particularly hard to sell in any market. (This scenario is reminiscent of Savings and Loans of the 1960s that faced a similar crisis when interest rates increased during the 1970’s.)
• Unrealized losses grew from almost zero to $4.8 billion at the end of 2022 and were estimated to be between $9.4 and $13.5 billion at the end of March.
• All of this, in addition to angst following SVB and Signature failures, explains why $100 billion of deposits were withdrawn in the first quarter of 2023.

Bank Accounting

 Accounting—love it or hate it—but a little understanding of bank accounting is necessary to make sense of the JP Morgan deal numbers. The example below is pulled from one given by Matt Levine for Bloomberg.

For many with a general understanding of accounting, bank accounting seems backwards.  The loans they make are assets, and the deposits they hold are liabilities--the opposite of a personal balance sheet. Here is the balance sheet for our simplified bank:

Capital ratio (equity/assets) = 10% (this needs to be positive)

When interest rates increase compared what is being earned on the loans issued by this bank, the value of the loans drops to $85. Here is the revised balance sheet:

Capital ratio (equity/assets) = -6%

If these loans are written down to their market value, equity is negative and the bank is technically insolvent. The FDIC can step in and seize the bank.

As with SVB, the revelation of unrealized losses triggered a run by depositors concerned about their uninsured balances. When adequate capital could not be raised to meet the demand for cash for deposits and the now realized losses on the loans that had to be sold, there was no option but to seize the bank and try to sell what it could.

What does the FDIC typically do in this situation? While it might not be the lowest short-term cost option (liquidating at $5 cost (deposits-loans in this case), it aims to sell the failing bank to a healthy bank. This effectively recapitalizes the failing bank when  the failing bank is sold to the healthy bank at a discount. In this case, selling the assets for $75 would make the balance sheet work. (The cost to the FDIC is that $15 on the Asset side.) 

Capital ratio (equity/assets) = 10%

The Deal

 The following breakdown of the deal also draws from Matt Levine’s explanation, as well as the other articles listed under “Resources.” Levine estimated what the First Republic balance sheet looked like on Sunday night.

Notes:

• FHLB-Federal Home Loan Bank Advances (they get paid first)
• Fed borrowing came from both the primary lending facility (discount window) and the Bank Term Funding Program created when SVB was failing.
• Remember that several big banks deposited $30b in an effort to rescue First Republic when the run on deposits started. JP Morgan Chase contributed $5b. These are included in the $92b in the table.

What did JP Morgan Buy?

Assets:

• Securities                        $ 30b
• Loans (market value)       $150b   (book value is $173b)
• Other Assets                    $   5b
• Intangible Assets             $    1b
  • Total                     $186b        

What Liabilities did JP Morgan Assume?

Liabilities

• Deposits                          $ 92b
• FHLB loans                     $ 28b
• Other Liabilities               $   2b
  • Total                     $122b

What else did JP Morgan pay for the transaction? (in addition to assuming liabilities)

• Upfront payment to FDIC                       $10.6b
• Payment in 5 years line of credit)           $50.0b        (JPMC will pay interest on this)   

Payments bring the total on the liabilities side to $182.6b. Equity of $3.4b makes the balance sheet balance.

What was the FDIC left with?

The remaining items from both sides of First Republic’s balance sheet remain with the FDIC.

Assets:

• $15b in cash
• $4 b in “other assets”
• $10.6b payment from JP Morgan now
• $50b payment from JP Morgan in 5 years
  • Total $79.6b

Liabilities

• $93b owed to the Federal Reserve

The bottom line for the FDIC is that it will be on the hook for about $13b that will come from the Deposit Insurance Fund.

What else might be useful to know about the deal?

• There is a loss sharing agreement between the FDIC and JP Morgan Chase in case any of the loans they acquired go bad.  This was critical for two reasons.
  • Due diligence period was VERY short for the deal.
  • This will allow JP Morgan Chase to operate with a lower required capital ratio. (Our simple example had 10%--the implied ratio here is a fraction of that.)
• All 84 First Republic branches opened Monday morning as JP Morgan Chase bank--all First Republic customers are now seamlessly JP Morgan Chase customers.
• $25b of deposits will be repaid to the other large banks in March

Stay tuned--there will likely be revelations and ramifications stemming from this deal in the days and weeks to come.  For now, we should be relieved that a banking crisis was averted.

Resources 

• Matt Levine Money Stuff details the accounting of the deal.
• CNBC gives a good overview of the deal and what led up to it, as does this Reuters article
• This first Reuters article explains why First Republic failed.
• This Reuters article explains the deal.

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.

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