The Best Solution for First Republic is in the Hands of the Big Banks

Introduction

I have hesitated to publish anything on First Republic Bank over the last month for fear of making things worse there. But since the "cat is out of the bag" due to the bank's April 24th disclosures, I think it's time to make this case.

The deposit run on March 17th at First Republic Bank wasn’t really the bank’s fault. They were caught in the crossfire from the Silicon Valley Bank failure despite managing their securities portfolio relatively conservatively, and their uninsured deposit levels, though on the higher end among larger banks, were far lower than those at Silvergate, Silicon Valley or Signature Banks.

No one wants this bank to fail. But, as people like to say in deal-land about tough situations, “it is what it is.”?The damage done to First Republic’s cost of funds in replacing deposits lost in the run can’t easily be undone, the franchise is fragile and a decision point is approaching quickly for the concerned parties, especially the FDIC and the eleven very large banks (the “Rescue Banks”) who contributed $30 billion in uninsured deposits to stabilize the situation.?

There really isn’t time for half measures.?First Republic disclosed some details of its situation and a vague restructuring plan on April 24th and its common stock immediately fell by 45%.?Speculation about future FDIC involvement has resumed and has the potential to drive more deposit outflows.?These risks will recur when the bank’s quarterly call report and next 10-Q are filed unless a solution can be found.?The last potential flashpoint is the refinancing of the Rescue Banks’ uninsured deposits.

The Rescue Banks and the FDIC have the most to lose if First Republic fails.?The FDIC loses out as administrator of the Deposit Insurance Fund and as First Republic’s primary federal regulator. The Rescue Banks pay either way—through special assessments if their uninsured deposits are protected or through losses on those deposits if they aren’t covered.

There is a private-sector solution for First Republic (Scenario 3 below) that can avoid most of these public and private costs.?The Rescue Banks can help themselves, and help the system, by buying and restructuring First Republic themselves in exchange for their uninsured deposits.?It’s unprecedented but it will work. And the Rescue Banks’ exposure is already so high that it makes financial sense as well.

The Current Situation

First Republic is losing money.?While analysts’ numbers vary some, the numbers disclosed in its bare bones earning announcement on April 24th suggest that its current net interest margin lies somewhere between zero and 40 bps, as opposed to 2.45% in the last quarter of 2022. That means its net interest income won’t come close to covering the bank’s non-interest expense minus non-interest income, even before all the charges for the announced 20-25% layoffs and other restructuring. Losses of that size mean that before too long the bank is going to have a capital problem?in addition to an earnings and liquidity problem.?

For a host of reasons, the best outcome for all the key constituencies---the bank’s customers, the Rescue Banks, the FDIC’s Deposit Insurance Fund and the Treasury Department on behalf of the U.S. Government, other lenders to First Republic like the FHLB of San Francisco, the Fed’s Discount Window and?Bank Term Funding Program, other banks who might have to pay the costs of a failure, and preferred and common shareholders-- would be a private acquisition and restructuring of the bank without government assistance.?First Republic is a wounded franchise with some fundamental problems—starting with the makeup of its balance sheet--but it has valuable and loyal customers and most of its problems can be fixed through the right deal.?

Unfortunately, a standard private bank acquisition is effectively impossible. First Republic has a loan portfolio filled with long-duration, interest-rate sensitive home, apartment, and commercial mortgage loans. In a normal environment, that just means that First Republic’s earnings are inversely related to interest rate movements.?Earnings go down when rates go up. But when the question is a “strategic alternative” sale to another bank, you get a different answer. Rising interest rates have put First Republic’s thrift-like loan portfolio so far underwater that the “mark-to-market” accounting applied in a private M&A transaction would crystallize interest-rate driven losses, deplete all of its existing capital and require too much new capital from a buyer to produce an adequate return for risk.?

The effect of?market repricing in an M&A deal would have on First Republic’s assets is very large. Fitch estimates that as of the end of 2022, First Republic's securities and loans carried unrealized losses totaling 16.3% and 13.3%, respectively, relative to amortized cost, or around $27 billion in total.?The company’s numbers are similar.

What’s more, the bank’s funding has been heavily repriced since the run and is now made up of high-cost wholesale deposits, Fed/FHLB borrowings and market-priced insured consumer and business deposits.?That means low-cost deposit funding won’t be available offset asset losses if the bank is sold.

Despite all this, the bank could theoretically limp along for a while in “zombie” mode, absent a second loss of confidence. First Republic’s Pro Forma CET1 capital position at 3/31/23 was a healthy 9.3% with Tier 1 leverage about 1% less, although operating losses and restructuring charges will steadily drive the capital ratios down over time.?Management could try to put the bank in a better position by retiring the expensive wholesale borrowings that replaced fleeing deposits and downsizing the bank. That in turn would require?some combination of internal cash generation through asset sales and/or a large equity capital injection. But the deeply underwater loan portfolio makes this type of restructuring extremely difficult to achieve without rapidly depleting capital, as the bank itself acknowledged in its recorded comments on April 24th.?And private equity investment in a bank raises a host of legal and regulatory questions around control and the Bank Holding Company Act that will be difficult to navigate in a short window. It’s not a viable prospect.

The Receivership Dilemma for the Rescue Banks

Before turning to why a Rescue Bank “bail in” makes sense, it’s worth reminding ourselves why, if First Republic were to fail, it could turn out to be the most expensive bank receivership ever for the FDIC and/or the Rescue Banks.

The FDIC has two choices when it comes to resolving a big bank. The FDIC, with the cooperation of other regulators, could use of the Systemic Risk Exception (the legal structure used for Silicon Valley Bank and Signature) to cover all deposits, including those of the Rescue Banks.?This would require that another systemic event take place, like a contagious bank run, which no one wants.?It would cost the FDIC as much as $34 billion to fill the mark-to-market hole in the First Republic balance sheet and sell loan assets (Scenario 1 below) while covering all deposits, including the Rescue Banks’ $30 billion in uninsured deposits.?

When the FDIC uses the systemic risk exception, the agency must collect a special, mandated assessment from banks to cover excess losses above what would have happened in a “normal” receivership where only insured deposits were covered.?The standards for allocating this special assessment among banks and holding companies were written to give broad discretion to the FDIC.?And if we take members of Congress, the ICBA, and Chair Gruenberg and FDIC board member Chopra at their words, the cost of receiverships under the systemic risk exception should be “allocated” to the Rescue Banks and the rest of the 158 larger banks and not to community banks—the 4,548 U.S. banks with under $10 billion in assets.

A standard “insured deposits only” resolution by the FDIC would reduce FDIC losses to zero and would probably allow for some payment to uninsured depositors and other creditors but would still result in the Rescue Banks taking billions in losses on the uninsured deposits they made in First Republic with the encouragement of regulators (Scenario 2 below).?Keep in mind that this will also create a conflict between the interests of the eleven Rescue Banks, who have uninsured exposure at First Republic, and the other 147 US banks with more than $10 billion in deposits who would clearly prefer this solution to another special assessment.

The Rescue Bank Bail-In Proposal

If, however, the Rescue Banks were to convert their $30 billion of deposits into 95% of the common equity in a surviving First Republic, the bank could be recapitalized and returned to health without any FDIC or government assistance. First Republic’s freshly marked-to-market balance sheet should be marginally profitable out of the box, and its customers are likely to stick with their First Republic private bankers so long as a transaction happens soon. First Republic can, if it chooses, shrink by selling excess assets to reduce high-cost borrowings and will need to find ways to manage its loan and deposit strategy differently and focus more heavily on non-spread businesses.?A smaller balance sheet would also allow quick return of excess capital to the Rescue Banks.?It’s reasonable to assume that the resulting bank, using a conservative 1% ROA and 8x P/E ratio, would have an equity value of $16B or more in the hands of the Rescue Banks and carryover shareholders.

Existing First Republic shareholders would be massively diluted in the recapitalized bank, as they should be.?The Rescue Banks would by necessity take a hands-off approach to First Republic, likely appointing an independent and expertise-based board of directors to evaluate and replace senior management as appropriate.?Contracts locking up the banks in the short term but facilitating the sale of their stock positions over time would ultimately result in a return of First Republic to widely distributed public ownership in its recapitalized and profitable form. Bank Holding Company Act compliance would be complicated, but manageable. The biggest challenge will be securing the required approvals from First Republic shareholders (now likely made up of hedge funds bound to create trouble) but given the alterative, which is a 100% loss of their equity, the incentives should be sufficient to get approval in the end.

Three Reasons for the Rescue Banks to Acquire First Republic

So why should the Rescue Banks do this “bail-in conversion” transaction? It’s messy, it’s complicated, it will distract from other priorities…you can hear the complaints already.?There are three reasons.

The first reason is hard dollars. As the scenario analysis below shows, it will likely be cheaper for the banks to rescue First Republic than to let it fail.?The FDIC is under bipartisan pressure to shift the cost of the Silicon Valley and Signature failures disproportionately onto the larger banks and away from smaller players. A bank like Citi is already be on the hook to pay over $2 billion for its share of the required special FDIC assessment for those two failures.?If First Republic fails and the government again invokes the systemic risk exception, Citi’s bill for that receivership alone could be more than $3 billion more. In a standard FDIC transaction, no additional deposit insurance assessment is likely, but Citi would lose two-thirds of its $5 billion uninsured deposit in First Republic.

The estimated $2.53 billion?value likely to be recovered by Citi if it converts its First Republic deposits into equity should, with added value from share repurchases as the bank shrinks and liquidation gradually or upon an ultimate sale or public refloat, be better for Citi than bearing its share of the cost of replenishing the deposit insurance fund and/or writing off its deposit position if First Republic fails.?

The same math applies to the other ten Rescue Banks. If they convert their deposits and take over First Republic, they can trade that last assessment hit or deposit write-off for something with better value plus an upside option on the bank’s figure.

(It’s worth noting that the math works just as well if the Rescue Banks team up with a strategic buyer and convert some, but not all, of their deposits into a minority equity position in the resulting entity, although the accounting and governance problems for a bank buyer get more complicated when it takes on minority investors who are also banks.)

The second reason is restoring trust. J.P. Morgan knew why he brought big bankers together to save the system in 1907.?His successor knew it too when he got the Rescue Banks to make uninsured deposits in First Republic earlier this month. The banking industry has gradually degraded public trust through decades of ill-advised risk taking and shoddy practices.?But trust can be earned as well as spent. This would go a long way to refilling the coffers.

The third and last reason is practical.?Public and political opinion in the U.S. is understandably outraged that a banking crisis requiring federal intervention has occurred so soon after the 2008 financial meltdown.?The failures of Silvergate, Signature and Silicon Valley Banks in March have exposed the vulnerabilities of specialized banking models in the digital age, at a cost to the FDIC of more than $22 billion to date. Another large and expensive failure will lead to unpleasant and possibly ill-considered regulatory and legislative responses that banks will have to live with for a long time.?Solving the First Republic dilemma without federal involvement should please regulators and Congress, cool things down, and make those most extreme outcomes less likely.

Appendix A: The Three Scenarios

The three scenarios are outlined in detail below:

·?????Scenario 1

o??FDIC SRE—Systemic Risk Exception (all deposits covered) Receivership

·?????Scenario 2

o??FDIC LCR Least Cost Resolution (insured deposits only covered) Receivership.

·?????Scenario 3

o??Big Bank Bail-in $30B Deposit Conversion

·?????Assumptions and Estimates for Scenarios 1 and 2

o??First Republic Liabilities at 4/21/23

§?Deposits at 04/21/23

·?????$103B total

·?????$53B insured

·?????$50B uninsured

§?Borrowings at 4/21/23

·?????$104B total

·?????$26B FHLB Long-Term

·?????$78 Fed and Other Secured

§?$1B Other Debt

·?????Note: Total receivership protected borrowings $104B at 4/21/23

o??First Republic Financial Assets at 3/31/23

§?Total $220Be

·?????Loans $173B

·?????Securities $37Be

·?????Cash $10B

o??First Republic Tangible Book Equity 3/31/23e

§?Total $17.4B

§?Preferred $3.6B

§?Common 13.8

·?????Scenario 1 SRE—$34B Loss to FDIC

o??Total assumed financial liabilities of $207B

§?Total Deposits 4/21/23 = $103B

§?Priority secured FHLB and Fed Borrowings of $104B.

o??Total earning assets and cash at 3/31/23=$220B

o??Book Equity at 12/31 $17.4B

§?Less Goodwill and Other ($0.8)

§?Less Preferred write off ($3.6B)

§?Add Back Preferred to Common $3.6B

§?Add Back Corporate Debt and Other $2B.

§?Net Common Equity $17.8B

o??MTM on loans and HTM securities ($26.5B) based on 12/31/22 reported mark

o??15% discount on loans to complete deal ($23.2B) (The two recent transactions had discounts above 20%)

o??Other Costs ($2B)

o??Total ($33.9B) Loss to FDIC

·?????Scenario 1 DIF Replenishment Charge

o??SRE Allocation (no chargefor?banks below $10B in assets)

§?($34 B) loss allocated.

§?> $10B banks have total assessment base of $18.4T

·?????Total assessment of 18.5 bps on large banks

·?????Citi $3.1B special assessment (vs $5B deposit)

·?????USBank $1B special assessment (vs. $1B deposit)

?

·?????Scenario 2 LCR -Estimated $16B Recovery by FDIC Before Partial Payment of Uninsured Liabilities

o??Total assumed financial liabilities of $147B

§?Total Insured Deposits 3/31/23 = $43B

§?Priority secured FHLB and Fed Borrowings of $104B.

o??Total assets at 12/31/22=$220B

o??Book Equity at 12/31/22 $17.4B

§?Less Goodwill and Other ($0.8)

§?Less Preferred write off ($3.6B)

§?Add Back Preferred to Common $3.6B

§?Add Back Corporate Debt and Other $2B.

§?Add Back Uninsured Deposits $50B.

o??Adjusted Net Common Equity $68.6B

§?MTM on loans and HTM securities ($26.5B) based on 12/31/22 reported mark

§?15% discount on loans to complete deal ($23.2B)

§?Other Costs ($2.9Be)

§?Gain/Loss to FDIC: =$16.B recovery

·?????Scenario 2--No DIF Charge

·?????Scenario 2 Loss on Rescue Bank $30B Deposits

o??68% LCR loss ($50B uninsured deposits-$16B FDIC net recovery = $34B loss on $50B=68% loss/32% recovery rate on uninsured deposits

o??Selected Rescue Bank Deposit Losses:

§?Citi ($3.4B)

§?USBank ($0.68B)

·?????Scenario 3--Equity Value Estimate

o??$30B deposits converted into 95% common equity

o??Recapitalized First Republic with 1% ROA at $200B or $2B net income at 8x PE or $16B market cap.

o??95% of $16B=$15.2B

o??Selected Rescue Bank Share Value:

§?Citi 5/30 = $2.53B

§?USBank 1/30 =$506MM

o??Potential to boost Rescue Banks’ return through rapid shrinkage of fully marked balance sheet dividend of excess capital to shareholder (e.g., $50B shrinkage = $5-6B dividend). Could be partially offset by lower market cap.