First Republic’s balance sheet as of 3/31/23 showed approximately $233 billion of assets and $215 billion of liabilities, leaving $18 billion in equity (https://ir.firstrepublic.com/static-files/013f57fb-b980-4353-bbb3-0e7a3b27f20a). A majority of those assets ($173 billion) were in the form of loans. So, theoretically, if one were to liquidate First Republic as of 3/31/23, you could sell all $233 billion of its assets to pay off all $215 billion of its liabilities and end up with $18 billion in cash.

Why would a bank that appears solvent according to its balance sheet experience such a swift decline into FDIC receivership and ultimate sale to JPMorgan at a discount?

A lot of the media has been talking about depositors’ panic causing a “run on the bank” (i.e., the liabilities side of the balance sheet suddenly coming due), but that doesn’t explain why a bank that has more assets than liabilities is suddenly in crisis. If the bank needed cash quickly to satisfy the depositors, it could sell all of its assets (i.e., loans) at fair market value and pay depositors. Sure, one could argue that this process would be difficult and cumbersome, and that only a few select players may have the capital to acquire the assets, causing a liquidity crisis.

Maybe this means that the assets would be sold at a slight discount, but why would the FDIC take $13 billion in losses and have to provide other large incentives ($50 billion in financing and 80% loss coverage for loans) to help rescue the bank?

One factor that is not often talked about is the fact that the value of the loans on First Republic’s balance sheet had to be deeply discounted in the calculation of JPMorgan’s bid. The value of these loans on First Republic’s 3/31/23 balance sheet was $173 billion, whereas the value of the loans for purposes of JPMorgan’s bid was $150 billion, a $23 billion difference.

As the cost of borrowing has gone up, the value of older loans made at lower interest rates has fallen.

Let’s take a simple example – say I make an interest only loan of $100,000 to John at an interest rate of 3% per annum for 10 years, and now I want to sell that loan to Bob. Bob doesn’t have money to buy that loan and has to borrow money to buy the loan at an interest rate of 5% per annum. Bob may still buy the loan but at a discount because he needs to make up for his cost of borrowing. Each year, Bob has to pay $2,000 more in his own borrowing costs than he’s receiving on the loan, so over 10 years he will have paid $20,000 in borrowing costs for this loan, making the value of the loan to Bob approximately $80,000, much less than the outstanding principal balance of the loan.

(Does this mean that for those people who locked in low mortgage interest rates in 2021, the value of the mortgage on your house could be less than the outstanding principal balance of the loan? Yes, possibly by a lot. For companies looking to deleverage their balance sheets, they may consider buying their debt at fair market value rather than prepaying at par value.)

Even marking First Republic’s loans at a $150 billion value, some have argued that JPMorgan got a very good deal on its acquisition (https://www.bloomberg.com/opinion/articles/2023-05-01/jpmorgan-got-a-deal-on-first-republic). It acquired $186 billion of First Republic’s assets for $182.6 billion ($122 billion of assumed liabilities, plus $10.6 billion in cash, plus $50 billion borrowed from the FDIC). The terms for the $50 billion loan have not been disclosed, but presumably this will be at a low interest rate. Given the fact that First Republic’s asset value was deeply discounted precisely due to increased interest rates, this seems like a windfall. JPMorgan’s own investor presentation describes the transaction as having an IRR of over 20%. (https://www.jpmorganchase.com/content/dam/jpmc/jpmorgan-chase-and-co/investor-relations/documents/events/2023/jpmorgan-chase-acquires-substantial-majority-of-assets-and-assumes-certain-liabilities-of-first-republic-bank-conference-call-/JPMorgan_Chase_Presentation.pdf) The loans JPMorgan acquired from First Republic are mostly high performing loans made to creditworthy, high net worth individuals, not the kind of loans held by banks that failed in the 2008 financial crisis.

All of this leaves me with a lot of questions -- Why are our banking institutions so sensitive to rising interest rates? Why didn’t First Republic purchase interest rate swaps or other derivatives to manage its interest rate risk? If all of America’s banking institutions had to mark their loan portfolios to market today, how much negative equity would there be in our banks? Why were the terms of JPMorgan’s deal so good and why weren’t there other competitors offering better terms?

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