First Republic Is in Limbo

Programming note: Money Stuff will be off tomorrow, back on Monday.

First Republic

The two options with First Republic Bank are pretty much:

1. Do something, or
2. Do nothing.

“Do something” is obviously bad. First Republic’s balance sheet shows about $233 billion of assets, including about $173 billion of loans, but the market value of those assets is considerably lower: Those loans are largely mortgages made at very low interest rates, and they have lost a lot of value as rates have gone up.. First Republic estimated as of Dec. 31 that its assets were worth about $27 billion less than their carrying value. 1  So figure its assets are worth something like $206 billion on a good day.

Meanwhile it has about $105 billion of deposits and about $105 billion of secured borrowing from the Federal Reserve and Federal Home Loan Bank system. Of those deposits, roughly $55 billion are insured by the Federal Deposit Insurance Corp. and roughly $50 billion aren’t; $30 billion of the unsecured deposits belong to a consortium of big banks that deposited money with First Republic last month to boost confidence. Roughly speaking, the insured deposits and the Fed/FHLB ($160 billion total) get paid back first, the uninsured deposits ($50 billion) get paid back next, and everybody else — subordinated debt, shareholders — gets paid back with whatever is left.

So if you can sell the assets for about $210 billion, then the government and all of the depositors get paid back in full; if you can’t, they don’t. (Either way, the shareholders are, uh, in trouble.) Again, the assets are worth something like $206 billion, based on First Republic’s filings in December; that would not quite be enough to pay everyone back. But the consensus seems to be that if you actually had to go sell everything at once, things would be considerably worse, and there would be a hole of tens of billions of dollars.

And so all of the do-something options are bad, because of that hole. The most straightforward do-something option is that the FDIC could seize First Republic, sell its assets, and use the money to pay back depositors. But there would be a hole of tens of billions of dollars. And the FDIC would either have to fill that hole (declaring First Republic systemically important and using its deposit insurance fund to pay off the uninsured depositors), or fill that hole (letting the uninsured depositors bear the loss). The Wall Street Journal notes

The details and extent of the FDIC’s support will be determined on whether they use the same tool, a so-called systemic risk exception, that allowed the agency to guarantee all of the depositors at last month’s two failed institutions.

Invoking that exception again would allow regulators to backstop all of the roughly $50 billion in deposits at First Republic that are above the FDIC’s insurance limit, including the $30 billion deposited by the big banks.

If the FDIC doesn’t make those depositors whole, it could reignite questions about such deposits at other regional banks, causing customers to yank their deposits from smaller firms. But if it does, the FDIC could be accused of bailing out Wall Street.

If the FDIC takes over First Republic at a loss, somebody — the uninsured depositors (meaning largely but not exclusively the big banks) or the FDIC (also meaning largely the big banks, who pay to fund the FDIC’s insurance fund) — has to bear the loss.

There are other do-something options that could happen in the shadow of an FDIC takeover: Another bank could buy First Republic and assume its deposits, or other banks could buy its assets at above-market prices, or banks or private equity firms could buy some equity in First Republic. Bloomberg News reports

A number of rescue proposals have so far failed to come to fruition. 

Earlier this week, Bloomberg reported that First Republic was looking to potentially sell $50 billion to $100 billion of assets to big banks that would also receive warrants or preferred equity as an incentive to buy the holdings above their market value.

By Wednesday, the firm’s advisers were privately pitching a similar concept, in which stronger banks would buy bonds off of First Republic’s books for more than they were worth so that it could sell shares to new investors. While that would mean booking initial losses, banks could hold the debts through repayment to be made whole.

But all of these have the same basic outcome, which is that somebody — probably, again, one or more big banks — steps in to bear the losses, to buy First Republic’s assets for more than they are worth. Nobody likes it:

The fate of First Republic Bank has become a game of chicken between the US government and the lender’s largest rivals, with both sides seeking to avoid steep losses and hoping the other will handle the troubled firm. …

Executives at five of the biggest banks, speaking on the condition they not be named, dismissed the notion of once again banding together to prop up First Republic, especially when it could mean paving the way for investors or a competitor to scoop up the firm at a bargain price. 

If the big banks bear the losses on First Republic, then whoever ends up owning First Republic — its current shareholders, a new buyer — won’t. You can finesse that a little bit with warrants — effectively, you make the banks who take the losses the new owners of First Republic — but the main problem doesn’t go away. The main problem is the losses.

The other option is “do nothing.” First Republic reported earnings on Monday, and they were legendarily awful

Across the industry, First Republic’s quarterly earnings report on Monday has come to be regarded as a disaster. The firm announced a larger-than-expected drop in deposits, then declined to take questions as executives presented a 12-minute briefing on results. 

But First Republic reported a profit, for First Republic, is that lots of its low-interest deposits have fled, and it has had to replace their funding by borrowing from the Fed, the FHLB and the big banks at much higher rates. Meanwhile it still has lots of long-term loans made at low interest rates. If you borrow short at 0% to lend long at 3%, and then your short-term borrowing costs go up to 5% while your loans stay the same, you will be losing 2% a year on your loans, and that is roughly the state that First Republic finds itself in. But it is not exactly the state that First Republic finds itself in: It still has some cheap insured deposits, some short-term assets, some floating-rate assets, some fee income, and in fact it has managed to scrape out a profit even as rates have moved against it. Can that last? I mean, maybe not

The deposit run has forced First Republic to rely on other, more expensive funding. That makes it hard to generate interest income, and at some point it might not be able to.

“They’ve never been super profitable,” said Tim Coffey, managing director and analyst at Janney Montgomery Scott. “Now you’re not growing and you’re layering on really high borrowing and funding costs.”

But a bank can stay in business even with some quarterly losses, as long as it remains well capitalized, and as a technical matter First Republic has enough capital to withstand some unprofitable quarters. And if you muddle along for long enough, the situation can right itself: The long-term low-interest loans will roll off and be replaced with higher-interest new loans, and First Republic’s interest margins will start to expand again. It might work! If you are a First Republic shareholder, “do nothing and hope the business recovers” is clearly the best option.

Of course deposits might keep flowing out, but so what? First Republic is now funded in large part with loans from the Fed and the FHLB, and I suppose they could just lend it some more money. When Silicon Valley Bank failed, the Fed put in place a new Bank Term Funding Program that was designed for more or less this purpose: The BTFP lets banks borrow against their assets without taking into account interest-rate losses, so that they can replace fleeing deposits with loans from the Fed. US regional banks spent years in a low interest rate environment, they were caught out by a rapid rate hiking cycle, and the Fed responded to that problem by lending them money to smooth out the transition. 

The advantage of doing nothing is that nobody has to take any losses now. But the regulators seem to want to move. Bloomberg again:

The clock for striking such a deal began ticking louder late last week. US regulators reached out to some industry leaders, encouraging them to make a renewed push to find a private solution to shore up First Republic’s balance sheet, according to people with knowledge of the discussions. 

The calls also came with a warning that banks should be prepared in case something happens soon.

And one way for something to happen soon is if the Fed stops lending to First Republic

As weeks keep passing without a transaction, senior [FDIC] officials are increasingly weighing whether to downgrade their scoring of the firm’s condition, including its so-called Camels rating, according to people with direct knowledge of the talks. That would likely limit the bank’s use of the Fed’s discount window and an emergency facility launched last month, the people said.

Why? Why close a bank and take billions of dollars of losses if you don’t have to? The consequences of doing something are obvious and bad; the consequences of doing nothing are a bit more diffuse.

But let’s talk about some of them. One is that there are legal limits on the Fed’s ability to keep propping up First Republic. I mentioned the BTFP, the Fed’s post-Silicon Valley Bank program that lends to banks at 100% of the face value of their collateral, even if that collateral has lost money due to rising interest rates. But only US Treasury and agency securities are eligible to be BTFP collateral, and First Republic’s assets are mostly loans. Those loans tend to be pretty — they are mostly mortgages to rich people — but they are very exposed to interest-rate risk, so they have lost a lot of value. And it can’t use them to borrow from the BTFP.

Meanwhile these loans are eligible collateral at the Fed’s discount window, its more standard lending program, but the discount window lends againstmarket value of collateral, and these loans have lost a lot of value. If deposits keep fleeing from First Republic, its ability to replace those deposits with Fed loans depends on the value of its assets, which means it might run out of capacity. If the FDIC is worried about that happening sometime soon, then there is some urgency to do something first.

More generally, the theory of central banking is that central banks should lend to solvent banks, but not prop up insolvent banks. The Fed’s statutes limit its ability to lend to undercapitalized banks. In some obvious economic sense, First Republic is undercapitalized — its assets are worth less than its liabilities, which is why we are talking about this — but legally it is fine and has plenty of regulatory capital.

But at some point, if the regulators conclude that First Republic is not viable, it is at least, like, embarrassing for them to keep lending it money. In the limit case, if all of First Republic’s deposits fled, you could imagine the Fed lending it $210 billion (up from its current $105 billion of Fed/FHLB money) so it could continue to limp along. But that’s bad! You don’t want a bank out there doing business, making loans, paying executive salaries, that is entirely funded by the Fed. You need some private-sector endorsement of the bank for the Fed to keep supporting it. 

Also: The losses have already happened. First Republic made loans at low interest rates, now interest rates are higher, and so its loans are not worth what they used to be. As an accounting matter, those losses don’t to be recognized yet; First Republic’s balance sheet is still technically solvent, and it can muddle along for a while. But  economically the difference between “the banking system reports billions of dollars of losses today and then normal profits afterwards” and “the banking system bleeds these losses into lower accounting profits for the next few years” is not that great, and the former is more clarifying.

Regulatory arbitrage

I used to be a corporate equity derivatives investment banker, which means that I’d go to companies and try to convince them to buy or sell options on their own stock. If you read a finance textbook, you will get the impression that derivatives are mostly about risk management, about hedging and speculation: People who own stock buy put options to protect themselves agains price declines, or sell call options to transform some of their potential upside into cash now; people who don’t own stock buy calls to take some cheap stock-price risk, etc. 

This describes almost none of what I was selling to these companies. What I was selling, much of the time, was tax deductions: We could build you a derivative that, sure, had the economic properties of some call options, but that took advantage of technical tax rules to get you extra deductions. 2  Other times I was selling accounting treatment: We could do a thing that had the economic properties of buying back stock, but that took advantage of technical accounting rules to juice your earnings per share a bit more. 3 Or I might be selling something like securities-law compliance: If you had some legal restriction on your ability to buy or sell stock, you could buy a derivative from us that was economically like buying or selling stock, but that avoided those restrictions. 4

In my line of work, derivatives were essentially about regulatory arbitrage: There were some complicated rules, created by legislators or regulators or accounting standards-setters, and those rules had the effect of rewarding some things and penalizing other things. And our job was to find a way to take something that the rules penalized and turn it into something that the rules rewarded, without changing its economic substance too much.

A famous example. The US tax code discourages short-term trading and encourages long-term investing. If you borrow a lot of money to rapidly trade stocks, you will be penalized, paying short-term capital gains rates. If you buy a long-term call option on a variable basket of stocks that you have management rights over, you will be rewarded, paying long-term capital gains rates. If you notice that those two things are the same, you can have a lucrative career as a derivatives structurer. (And get in trouble: This is the Renaissance Technologies tax trade, and it ended up not working

The lesson that I learned from my career as a derivatives structurer is that much of finance is about this sort of regulatory arbitrage. Economic life is socially constructed, society has rules, and you can make use of the rules to make money.

Sometimes the rules change and particular businesses get harder. But there is a sort of conservation law at work; the rules for complex systems have to be somewhat complex, and if you have mastered the current complexities you can probably figure out how to make money off new and different complexities. Tax trades sometimes get shut down by new tax rules, but that doesn’t put tax structurers out of work; they’re the ones who are best positioned to figure out the new tax trades enabled by the new rules.

Sometimes some whole new area of economic life gets brought into the domain of rules, and a new industry springs up to game it. In my lifetime, environmental, social and governance investing went from an academic idea to a huge business with all sorts of competing and economically important regulatory and accounting regimes, and so there are lots of people in the financial industry working on ESG arbitrage. 5  “ESG Consultant But Evil,” I sometimes call this job, and we talked last week about how companies whose business is cutting down trees can get environmental credit for the trees they don’t cut down. That is the purest form of financial engineering: Some accounting regime exists that rewards you for not cutting down trees, you are in the business of cutting down trees, and you find a way to make cutting down trees , for the relevant accounting purposes, like not cutting down trees.

More rarely, some set of rules will go away or be simplified in a way that really does demolish someone’s business niche. For instance, there is, in the US, saying that bank accounts are insured by the Federal Deposit Insurance Corp. up to $250,000. FDIC insurance is valuable, but you cannot pay the FDIC directly for the amount of insurance that you want: If you have $250,000 in your bank account, it is all insured without you doing anything; if you have $2,500,000, it mostly isn’t, and that’s just that. But of course you can open 10 accounts at 10 banks and put $250,000 in each of them; then they will all be insured. If you have $25,000,000, you can open 100 accounts at 100 banks, but that is pretty annoying. But someone can open 100 accounts for you at 100 banks, and put $250,000 in each of them, and charge you a fee. That intermediary is selling you FDIC insurance, and charging you a fee for it, because it has found a (fairly straightforward) way to structure around this one FDIC rule.

And that really exists and is a business (“brokered deposits”). And if the FDIC tinkered with its rules in some way — if it changed the rules so that all of a household’s bank accounts at one bank counted together toward the limit, or so that checking and savings accounts at the same bank counted separately, or whatever — then probably the intermediaries who currently sell this product would be best positioned to sell a revised product to comply with the new rules; they are the experts at FDIC insurance cap structuring.

But if the FDIC did away with the limit entirely they’d be out of business. David Dayen reports

Legislation has been proposed to uncap deposit insurance. And that has prompted the private equity–owned company that is one of the main beneficiaries of the cap to spring into action.

A company called IntraFi offers two products that allow large depositors to spread their money among a network of hundreds of banks, each with accounts that don’t exceed the cap and are therefore effectively covered in full by deposit insurance. The company takes a fee for facilitating these “brokered deposits.” If deposit insurance were uncapped, their business model would be worthless.

The prospect of uncapping has the extremely well-connected officials at IntraFi scrambling. In the first quarter of 2023, when Silicon Valley Bank was shuttered, IntraFi tripled its lobbying expenses and hired a firm known for its access to senior congressional leadership. The new lobbyists who registered to work for IntraFi have experience with senior members of Congress, as well as the Trump and Obama White Houses. It’s a full-court press to maintain a lucrative status quo. …

Brokered deposits have been heavily criticized by former FDIC chair Sheila Bair, who described them as “just gaming the FDIC rules. The FDIC takes all the credit risk, and Promontory [IntraFi’s predecessor] gets the profit.” 

Sure, yes, I don’t disagree, I’d just point out that “[] is just gaming the [government agency] rules; the government takes all the credit risk and [] gets the profit” describes a surprisingly large portion of finance!

Crypto money markets

Here is a story that you could tell about crypto in 2020 and 2021. Interest rates, in the US, in traditional finance, were very low. If you had some money and you wanted to earn a yield on it, and you put it in the bank, you’d earn roughly 0% interest, and you’d be sad. Crypto found a solution to this. The solution was that crypto platforms — exchanges, lending programs, etc. — would take your money and lend it to absolutely wild leveraged degenerate crypto traders, who would pay high interest rates on that money so they could gamble with it. 6 For a while crypto mostly went up, the gamblers mostly made money and paid their interest, and you could get, like, 18% yields on bank-account-ish-looking crypto accounts. And then this system, which was as dumb as it sounds, collapsed, and crypto platforms like Celsius and Voyager and BlockFi went bankrupt.

This system collapsed for a number of reasons, but probably one of them was that the Federal Reserve raised interest rates, which reduced the value of speculative assets like crypto. But there is a bright side to that, for crypto, which is that now if you are a crypto platform and you want to attract deposits by promising to pay interest, that is much easier. You can take your customers’ money and buy Treasury bills yielding 5% and pay them 4% and keep the difference, instead of taking your customers’ money and flinging it into crazy leveraged gambling and losing it and going bankrupt. This is not, I suppose, “crypto,” in some relevant sense, but you do it on the blockchain, blah blah blah, it’s crypto Wall Street Journal reports:

“The high-yield DeFi app era is over,” said Sidney Powell, chief executive of decentralized lender Maple Finance.

As of Tuesday, one of the biggest DeFi platforms, Aave, was offering a 30-day deposit rate of only around 2% for the two largest stablecoins, cryptocurrencies pegged to the dollar.  

Maple Finance is among a host of crypto firms seizing on the higher yields and relative safety offered by U.S. government bonds. Last week, the company launched a product that will earn interest equivalent to a one-month Treasury bill minus a fee on deposits—offering a yield of about 3.4%.

This is how the product works: non-U.S. accredited investors can deposit USD Coin into the “cash management pool” and receive tokens that represent their ownership in exchange. The pool then issues a loan to an entity managed by crypto hedge fund Room40 Capital, which will invest customer deposits in one-month Treasury bills.

Is this product better than a money market fund? Well! The money market fund (1) seems to pay higher interest and (2) does not involve LENDING YOUR MONEY TO CRYPTO HEDGE FUND ROOM40 CAPITALto buy Treasury bills. But this product does have the advantage of being cryyyyyyyyyypto:

Proponents of these new products say they appeal to big crypto investors who want to keep stablecoins on hand for fast trading and earn a return on idle cash.

Of course, traders can always sell their stablecoin holdings and park them in Treasury bills directly without taking the risk of going through a third party and paying a fee. 

But where is the fun in that. In the olden days, crypto paid higher yields than traditional finance, to compensate people for taking enormous amounts of risk. Now it pays lower yields than traditional finance and, uh, well. To be fair, Maple explains that “assets are held in standalone single purpose vehicle, custodied by a regulated prime broker and Lenders have full recourse over all assets.” 7

Elsewhere in investing crypto stablecoin assets in Treasury bills

Franklin Templeton says its money-market fund that records share ownership on a blockchain is seeing inflows from crypto-related entities in the aftermath of the shuttering of several industry-friendly banks. 

Total assets in the Franklin OnChain US Government Money Fund (FOBXX), which was launched in 2021 and became publicly available last year, have increased to around $270 million. The fund uses the Stellar blockchain network to process transactions and record ownership. The fund invests in US government securities, cash and repurchase agreements and doesn’t hold any cryptocurrencies. …

The fund even has a digital token called BENJI that represents shares of the funds. One share of the fund is maintained at one dollar. The tokens are currently not transferable between fund investors, but executives at the asset manager said that bringing utility to the token is on the roadmap of the firm.

talked about this fund back in 2019, and I love it, though I still wish that they called the token a “Benjamin.” One way to think about the BENJI is that it is a stablecoin that is worth a dollar, lives on the blockchain, is invested in safe assets by a regulated entity and (unlike most stablecoins) pays interest. Another way to think about the BENJI is that it is just a normal government money market fund, except that the people promoting it say “blockchain” a lot, so if you are a crypto investor you will feel better about giving it your money. 

Things happen

Charles Schwab, Being a Big Bank Has Become a Big Problem. Fed Bosses Steered Examiners Away From Probing Problems Like SVB. Regional US banks claimed easier capital rules would turbocharge loans. US companies in distress turn to debt exchanges to dodge bankruptcy. Powell Faces Pushback Inside Fed Over Need to Cool Wage Gains. Fed’s Jerome Powell Tricked by Russian Pranksters Posing as Zelenskiy. JPMorgan Creates AI Model to Analyze 25 Years of Fed Speeches. Wall Street’s New Trade: Covid-19 Insurance ClaimsDeutsche Bank Plans More Job Cuts After Traders Trail Peers. Deutsche Bank says it was hit by a ‘speculative attack’ during turmoil. Deutsche Bank Seeks to Win Over Credit Suisse Clients, CFO Says. Japan’s SMBC plans to triple stake in Jefferies in Wall Street push. Congress Pushes to Police Stock Trading by Federal Officials. Chinese Authorities Question Bain Staff in Shanghai. Hong Kong SFC to Issue Crypto Exchange License Guidelines in May. Bed Bath & Beyond Shoppers Hurry to Use Their Stacks of Coupons for the Last Time. Former Fugees Rapper Pras Michel Convicted of Role in Foreign-Influence Scheme Tied to 1MDB. Women CEOs (Finally) Outnumber Those Named . “‘I thought I was buggin’! I was like, Yo, there goes a ... peacock!’ he recalled, saying he assumed he was just too ‘high.’”

If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters . Thanks!

1. See page 180 of First Republic’s annual report, showing mortgages worth about $117.5 billion (against $136.7 billion carrying value), other loans worth $26.4 billion (against $29.3 billion), municipal securities worth about $16 billion (against $19.4 billion), agency mortgage-backed securities worth $6.4 billion (against $7.3 billion), etc.; the total difference is about $26.9 billion. Since then rates have moved and the balance sheet has changed, so don’t take that number too literally.

2. The key trade here is the convertible bond call spread. Here is a column I wrote about the economics of the call spread, but the important part is footnote 3, about the tax treatment.

3. Here the key trade is the accelerated share repurchase. Here is a column I wrote about the economics of the ASR, but the important part is footnote 2, about the accounting treatment.

4. Various trades here. For a company, an ASR is one way to implement a 10b5-1 plan to buy back stock even when you are not in an open window. For an activist, a total return swap is a way to economically buy stock without triggering disclosure requirements. For a big shareholder, a funded collar is a way to economically sell stock while still being able to say you are a shareholder (and having voting rights, etc.).

5. Also: crypto.

6. You could tell a more nuanced and crypto-y story in which they were using the money to earn yield by staking tokens or providing liquidity or whatever, but at a high level — and in terms of realized results — they were mostly gambling. The key text here is probably Kyle Davies’s absolutely astounding explanation of Three Arrows Capital’s “arbitrage” trades, which we discussed in December. “We will lend money to a sophisticated market making firm to conduct arbitrage trades that earn steady profits that it can use to pay off the loan” sounds reasonable-ish, until you hear Davies describe what those arbitrage trades were.

7. What *is* the trade here? Here is Maple’s deck on the strategy, but to me the hard part is that Room40 is getting USDC (a stablecoin) and buying Treasury bills, presumably using dollars. It needs to convert the USDC into dollars, which I think means borrowing dollars secured by USDC?

To contact the author of this story:

Matt Levine[email protected]

To contact the editor responsible for this story:

Brooke Sample[email protected]