First Republic’s jumbo mortgages brought on bank’s failure

New York - The seeds of First Republic Bank’s downfall were sown in the jumbo mortgages of Silicon Valley, where a unique strategy to loan wealthy individuals extraordinary sums of money blew up in spectacular fashion.

In the early 1980s, First Republic chairman Jim Herbert, then running San Francisco Bancorp, wanted to get into a new line of business. The Bay Area’s high earners were coming to him and asking for unusually large loans to buy pricey properties in the area.

“Why don’t we do a couple of these and see how they go? Can’t bankrupt the whole bank,” Mr Herbert said to the firm’s president, according to an account of the conversation on First Republic’s website.

Years later, after Mr Herbert left San Francisco Bancorp and founded First Republic, his new bank became known for handing out interest-only mortgages at rock-bottom rates to borrowers with high incomes and exceptional credit scores. Typically, they did not have to start repaying the principal for a decade.

Demand for the loans surged during the Covid-19 pandemic as wealthy buyers sought mortgage deals that would allow them to keep the bulk of their money in higher return investments. The rush helped First Republic double its assets in four years. It also contributed to its collapse.

In the early hours of Monday morning, JPMorgan Chase & Co

agreed to acquire First Republic from the Federal Deposit Insurance Corp (FDIC),

which seized the bank after a tumultuous period in which its stock had cratered and depositors had pulled almost half their money. Just a few weeks earlier, Wall Street’s biggest banks had stepped in to shore it up with their own cash.

The deal marks the second-biggest bank failure ever in the United States and the third in 2023 alone, bringing March’s banking crisis back into focus after a relative lull in the weeks since Silicon Valley Bank (SVB) and Signature Bank went under.

Jumbo mortgages

At the centre of First Republic’s balance sheet was a US$137 billion (S$183 billion) problem that made it a particularly hard sell: A giant book of those low-interest mortgages, mixed with some others, whose value had been severely dented since the US Federal Reserve started raising interest rates.

At the start of 2023, First Republic said its mortgages would be worth about US$19 billion less than face value if sold off. It also had another US$8 billion or so in markdowns on other loans, as well as unrealised losses on bonds.

Potential bidders quickly realised that, in a sale, those US$27 billion in unrealised losses would completely wipe out the firm’s US$13 billion in tangible common equity. Analysts began speculating that even at zero dollars per share, no one would bite.

JPMorgan now owns about US$173 billion of First Republic’s loans, US$30 billion of securities and US$92 billion in deposits. It will share any losses on the firm’s single-family and commercial loans with the FDIC, and repay the deposits that the other banks put up in March.

In some ways, Sunday’s resolution was a win for the FDIC. Unlike the drawn-out, multi-week effort to shift SVB off its books, the deal was done and dusted in a weekend, just as the regulator prefers.

But it leaves bigger questions for the banking industry at large – namely, can a private solution for a flailing bank, as the JPMorgan-led group attempted in mid-March, ever really work? As one senior executive at a bank that contributed money to the effort said: It certainly could not be done more than once.

“This is another one-off solution to the liquidity crisis,” analysts James Fotheringham and Rufus Hone of BMO Capital Markets wrote in a note on Monday. “We worry the market will find another target for funding concerns.” bloomberg