What Happened?
First Republic Bank (ticker: FRC), 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 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 Fund (for comparison, the estimated cost of Silicon Valley Bank was $20 billion and Signature Bank’s cost was $2.5 billion). As part of the transaction, FRC's 84 branches in eight states reopened as branches of JPM (Chase Bank) today, and all FRC 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, FRC is now the second-largest US bank failure after Washington Mutual (which JPM also took over back in 2008).
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 FRC equity nor assuming FRC'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. 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.
Market Implications
We view JPM's FRC takeover as a positive outcome for the US banking system, JPM and FRC depositors. Systemic fears should decrease going forward as we believe the US banking system is healthy, and FRC will likely be the last major US bank to fail in this cycle. Silicon Valley, Signature Bank and FRC 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 FRC and Signature Bank's operating company bonds.
Despite the aforementioned headwinds, deposit (out)flows in Q1 out of regional banks were manageable (with FRC 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 bps) 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 FRC depositors, but a worst-case outcome for FRC investors.