CWS Market Review – May 2, 2023

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JPMorgan Chase Buys First Republic

A few weeks ago, when Silicon Valley Bank went to the great clearinghouse in the sky, one of the points I stressed is that in a banking crisis, you never know who’s next. Some folks thought the banking mess was over and that we could get on with our lives.

Not so fast. Investors were keeping a close eye on any bank that had a high percentage of uninsured assets. That naturally led them to First Republic (FRC).

That’s hardly a surprise because in many respects, FRC is quite similar to Silicon Valley Bank. It’s based in California. It catered to the tech community. It had a high percentage of uninsured deposits.

(This chart is like a real-life version of Nassim Taleb’s chart of the days in the life of a Thanksgiving turkey.)

Low rates and lots of cash funded a boom for many of these regional banks. Once interest rates turned northward, the business model unraveled. FRC tried to borrow to fill the gap, but that made the problem worse.

The FRC story is different in one key respect: it was thought to have a good chance of making it through this chaos. If you recall, several big banks, including JPMorgan, injected $30 billion into FRC to keep it running.

First Republic had a simple business model: focus on very wealthy customers and give them top-of-the-line service. Being based in San Francisco, FRC also had an important toehold in the tech world.

First Republic opened branches in wealthy neighborhoods. The bank even had a branch inside Facebook’s HQ. Under one deal, Google employees could get a $2,000 bonus by opening an FRC account. The bank gave the Zuck a $6 million mortgage with a rate of 1.05%.

With rates at 0%, all was sunny. FRC paid very low interest on deposits and used its money to fund high-end projects or to mortgage second homes. The loans rarely went bad.

What Went Wrong

The problems started when rates started going up. Rich people like money and they really like it when their money makes money. FRC had to compete or face losing customers. They chose the latter.

Let me clear something up. The real problem wasn’t interest rates going down, or rates going up. Instead, it was the jolt from rates going down, then quickly going up. These banks were caught off guard.

To give you an idea of the impact that higher rates had, in Q4 of 2022, FRC paid $428 million in interest. In Q4 of 2021, they only paid $20 million. The bank felt it was fine because it had a ton of mortgages on its books. The only problem that could possibly arise would be if it had to dump those mortgages to pay off fleeing depositors. Take a wild guess what happened.

In FRC’s Q1 earnings report, the bank confirmed that depositors had taken out $100 billion worth of deposits. That’s staggering, but the CEO was telling a different story.

Since it was losing depositors at such a fantastic rate, FRC had to turn to the Federal Reserve to borrow money. Lots of it—and not particularly cheap debt, either. Recently, FRC accounted for roughly three-fourths of all of the Fed’s lending.

Things went from bad to worse. On FRC’s earnings call, CEO Michael Roffler tried to reassure investors. That didn’t work. The bank withdrew its previous guidance, and Roffler didn’t take any questions. Bear in mind that more than two-thirds of FRC’s deposit base was uninsured.

FRC was looking for another round of capital from the big banks. The plan was that the banks would overpay for FRC’s bonds. As a result, FRC could more easily borrow money. That wasn’t exactly popular with the banks. FRC’s stock dropped in half in one day.

In the old days, you did a bank run by lining up outside the bank. Nowadays you do it with a smartphone. Same idea, just a lot faster.

Over the weekend, the regulators had seen enough, and they stopped the fight. After 38 years in business, First Republic is no more. The bank has (had) $233 billion in assets. That makes it the second-largest bank failure in U.S. history, just behind Washington Mutual in 2008.

The banking regulators in California turned FRC over to the FDIC which held an auction for FRC’s assets. The regulators wanted to see who was interested and how much they were willing to pay.

We don’t know the precise details, but the key players were JPM and PNC Bank. Bank of America reportedly pulled out. In the end, JPM was the winner. JPMorgan will pay the FDIC $10.6 billion for the remains of FRC.

There’s little doubt that JPM is getting a very good deal. Ultimately, JPMorgan Chase will get all of FRC’s deposits plus a “substantial majority of assets.” JPMorgan will get about $92 billion in deposits. The bank is also taking on $173 billion in loans and $30 billion in securities.

It doesn’t end there. The FDIC will share losses on any mortgages and commercial loans that JPM will assume. For good measure, the FDIC also threw in a $50 billion line of credit. The FDIC clearly wanted a deal done fast. The key part is that depositors will be protected, and shareholders won’t. At one point on Monday, shares of JPM were up close to 4%.

The FDIC’s insurance fund will take a $13 billion hit. SVB caused a $20 billion ding. In a statement, the FDIC said, “First Republic Bank’s 84 offices in eight states will reopen as branches of JPMorgan Chase Bank.” By the way, at the end of Q1, JPM reported total deposits of $2.4 trillion.

In February, shares of FRC were as high as $147 per share. The stock closed Friday at $3.51 per share. JPM CEO Jamie Dimon said, “This part of the crisis is over.” Dimon added, “There may be another smaller one, but this pretty much resolves them all.”

Eh, I’m not sure Jamie’s right about that. The regional bank sector got slammed again today. The Regional Bank ETF (KRE) was down more than 6% on Tuesday. Two of the big losers today were PacWest Bancorp (PACW) and Western Alliance (WAL).

Simple rule: If you’re a bank with some form of “west” in your name, today was probably a rough day.

Banking panics aren’t too dissimilar from zombie movies. You never know who’s been infected until it’s too late. Jamie Dimon said, “everyone should just take a deep breath.” You, first.

The banking mess isn’t over. There are still a number of trouble spots out there. Be very cautious about going bargain-hunting in the regional bank sector. My favorite is still Hingham Institution for Savings (HIFS), and even they’ve been knocked around.

Yesterday, the FDIC proposed increasing the limits for deposit insurance. Congress would still need to sign off on it. It’s easy to blame the fat cats until you realize that many companies keep their payrolls on deposit. When a bank goes under, some small companies may not be able to pay their workers.

There’s a faint ring of familiarity with the events of this spring and the Panic of 1907. The event at the center of that crisis was the failure of the Knickerbocker Trust Company. The trust generously funded a harebrained scheme to corner the market on United Copper.

When that didn’t work, there was a mad scramble to find out who else was exposed to the deal. Just like today, the fear was about contagion. Finally, J.P. Morgan, this time the man, not the company, decided he had seen enough. He publicly said he would stand behind several banks, and the frenzy soon ended. Just like today, the panic ended with JPMorgan.

One important postscript to the Panic of 1907 is that it led to the establishment of the Federal Reserve in 1913.

Expect the Fed to Hike Rates, But Then What?

Speaking of which, the Federal Reserve began its two-day meeting today. The Fed will release its policy statement tomorrow afternoon at 2 p.m. I’ll spare you the suspense. The Fed will almost certainly raise short-term interest rates tomorrow by 0.25%.

There’s been some news lately that suggests that the Fed may want to take a pause for a few months. For example, the most recent GDP report showed that the U.S. economy grew in real terms at an annualized rate of 1.1%. That’s not so hot. Job openings are now at their lowest level in nearly two years.

We’ve also seen better inflation numbers. The year-over-year inflation rate has gradually fallen from 9.1% last June to only 5.0% for March.

On Friday, the government released the PCE price index for March. This is important because it’s the Fed’s preferred measure of inflation. For March, the core PCE increased by 0.3%. That matched Wall Street’s estimate.

Over the last year, the core PCE has increased by 4.6%. Last June, the 12-month core PCE peaked at 7. That was a 41-year high.

On Monday, the ISM for April came in at 47.1. That’s a slight increase over the 46.3 for March. Still, it’s below 50 which indicates that the factory sector of the economy is contracting.

If the Fed hikes this week, it will be the 10th consecutive hike at 10 consecutive meetings. The latest futures prices indicate a 92% chance that the Fed will hike. That would bring the target range for the Fed funds rate to 5% to 5.25%.

After that, the futures market sees the Fed pausing for six months. In November, traders expect the Fed to start cutting rates. Traders see the Fed cutting by a full 2% in just over a year. That pretty much means that a recession is expected.

In the entire yield curve, the highest-yielding Treasuries are the ones maturing this August. That also suggests that the Fed may start lowering rates soon.

Lowering interest rates tends to be beneficial for stock market valuations like the Price/Earnings Ratio. Notice that I didn’t say stocks. That’s because the valuations tend to increase at the same time that earnings are decreasing. The P/E Ratio goes up as the E goes down.

The April jobs report will be out this Friday. Wall Street expects an increase of just 180,000 net new jobs. The report for March showed an increase of 236,000 jobs. That was the smallest increase in more than two years. The April CPI report is due out on Wednesday, May 10. If inflation and jobs come in lower than expected, we may see the Fed cutting rates by this fall.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you want more info on our ETF, you can check out the ETF’s website.

Posted by on May 2nd, 2023 at 6:06 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.