First Republic: who eats the ~$9bn?

Interesting piece in this morning's FT "Unhedged" newsletter :

First Republic: who eats the ~$9bn?

Often, when a bank is in serious trouble, something gets done about it on a Friday afternoon, giving everyone involved the weekend to work out the details before the market opens on Monday. Well, today is Friday and First Republic is in serious trouble. So maybe something will happen this afternoon. So let us review, exactly, what details have to be worked out.

Here is First Republic’s balance sheet as of March 31:

This looks like a properly functioning bank’s balance sheet, but it isn’t, for two reasons. The debt liabilities — basically all owed to bits of the US government — are very expensive, likely rendering the bank unprofitable. Second, there are big mark-to-market losses in the securities and loan portfolios. First Republic’s most recent estimate of those losses, at the end of last year, was $27bn. The losses are probably a little smaller now because rates and spreads have moved around, but in the hypothetical balance sheet below I’ve taken all $27bn out, to render an estimate of the balance sheet in a sale or resolution:

To a first approximation, someone has to eat?$9bn in losses, or maybe a bit less. It’s not going to be debt holders, which are the Fed and the Federal Home Loan Bank of San Francisco. They are secured creditors who hold collateral against their loans. The insured depositors are of course safe.

So it comes down to two classes of uninsured depositors: the 11 big banks who put in $30bn in emergency funds, and whoever else has, for reasons known only to themselves, left $20bn in uninsured money in First Republic. It is not clear at this point whether either class has priority over the other.

Some of you may be thinking that Treasury secretary Janet Yellen and the other authorities should just stick the magnificent 11 with the losses. They are big banks, who everyone hates, and First Republic is a banking industry problem. But as Steven Kelly of the Yale Program on Financial Stability pointed out to me, Yellen et al will need the goodwill of the big banks should some other bank or banks get into trouble. The easiest way to resolve a smallish bank’s troubles is to have a big bank or banks buy it, and let the problems “drown in the bigness”, in Kelly’s words. Regulators want to retain this option, so pissing off big bank CEOs is not optimal.

Indeed, some sort of arranged sale seems like the most likely resolution in this case. If a big bank or banks buy the loans and securities at above-market values, as has reportedly been proposed, they would take an accounting loss at the outset, but could match those assets against their own inexpensive funding, possibly achieving a positive spread, and then hope for rates to fall. It’s a fudge, not an ideal solution, but it would save the banks from taking outright losses on their deposits and save the authorities from doing another outright depositor bailout.