First Republic was a rotten bank, and on Monday, JPMorgan Chase bailed it out. It had been a terrible few weeks for First Republic, which is now the second-largest bank failure in U.S. history. Depositors fled. Its stock crashed 95 percent. After the bank got its first bailout in March, executives effectively told Wall Street that they had no right to pry into the company — an act of hubris that ultimately hastened its collapse. This morning, JPMorgan CEO Jamie Dimon declared that “this part of the crisis is over,” a reference to the ripple effects from the demise of Silicon Valley Bank some six weeks ago. But this probably isn’t the end of the crisis. “What’s emerged will come with collateral damage and unintended consequences,” Mohamed El-Erian wrote in a column this morning.
There is a large contingent on Wall Street that is viewing this takeover with a sigh of relief. It could have been much worse. First, let’s just get this out of the way: This was not a 2008-style bailout. First Republic got a Tarantino-esque death — quite gruesome compared to the concierge euthanasia the Federal Reserve gave to SVB last month when the central bank declared it too big to fail after it had already collapsed (meaning all its deposits could be insured). Taxpayer money isn’t being funneled to prop up First Republic right now — though whether or not these risks are ultimately borne by the public remains to be seen. JPMorgan is buying the company at a very steep discount — $10.6 billion for a company that was valued at more than 20 times that just a few months ago.
But the public can end up on the hook, and this is what has people like El-Erian so worried. The Federal Deposit Insurance Company is the entity that is assuming the vast majority of all the potential losses here. The FDIC is a private corporation — not a government entity. It is funded by banks, including those that are too big to fail. Does it matter? It’s unlikely that JPMorgan will keep much of First Republic’s highly questionable mortgage-lending portfolio on its books — it will probably just sell them off to investors. But it could very likely have to do so at prices lower than it would want. Still, JPMorgan will probably look at this in the future as a great deal, one where they bought a big bank for cheap and the risks never materialized.
The way that First Republic got so large is by taking the basic banking model and trying to get rid of all the boring parts. The way a bank works is pretty simple as a concept: It takes in deposits at a cost, and lends out money for profit. The cash it gets in deposits get reinvested in the broader market — typically Treasury bonds, which have low risk of default (at least, for now). The hard and boring part of that is making sure that deposits don’t dry up and loans are actually profitable.
When it came to doing that, First Republic was terrible: Bloomberg reported that a cornerstone part of its business was giving out jumbo mortgages with paltry interest rates, some of them under 3 percent. Not only that, but borrowers didn’t have to pay back the principal for ten years. This was pure quid pro quo, a deal aimed only at the wealthiest and most powerful — Goldman Sachs president John Waldron was a borrower — in order to get them to park their cash there. These low-interest loans were part of what did in First Republic. The dramatic rise in interest rates over the past year made the Treasury bonds the bank was holding less valuable (at least temporarily). That meant it had less access to cash that it owed its depositors if they decided to pull their funds. (As Christopher Whelan of Institutional Risk Analytics points out, its investment banking business, a critical source of money, also dried up this year). Then, after Silicon Valley Bank collapsed in March, depositors did just that — they fled. There were about $8 billion in unrealized losses and markdowns on the bank’s books.
If this all sounds familiar, it’s because it’s very similar to what to happened with Silicon Valley Bank. SVB also had a mismatch in its assets and liabilities. SVB was also giving sweet deals to executives in order to bring in easy cash, not only with its loans, but also through its powerful venture-capital arm, according to former employees and investors I’ve spoken with. Of course, all banks do this to some extent. That’s why “private client” services at Chase give better terms. But these were banks that had no buffer.
This exposes something else about how the economy really works. When it comes to the U.S. financial system, there are two sets of rules. One set is for those that are too big to fail — your JPMorgans, your Goldman Sachses. They have stricter requirements for operating, including carrying more cash in case of sudden losses, and being more discriminating when it comes to who they loan out to and at what rates. The other set is everybody else. They don’t have to have as many rules, but because they’re smaller, they’re freer to take on more risks, because a collapse, in theory, wouldn’t matter to the broader financial system. But for years, the sweet spot was to be just under the line that separated the too-big-to-fail banks from the rest, and that is the zone where First Republic, as well as SVB, thrived. That way, as banks, they had lots of money but fewer rules on how to run their business.
Not every bank that’s failed this year has been a tech bank, but it is conspicuous that the bulk of those assets do come from California, and that Dimon, the only CEO still left from the financial-crisis era, is the most prominent white knight. The death of First Republic and SVB are really the end of the consequence-free era of low interest rates, when whatever it was that was happening in California was the driver of the broader economy — not because it made any sense or did any good, but just because it was gushing money. It is also, in a fundamental sense, what will probably be part of a shift back to New York in terms of power. These banks were the consiglieres of the Palo Alto set. Now that Wall Street is acquiring them, or just getting their deposits, there are new rules for this Silicon Valley money — and those rules are, in turn, set by the Washington regulators who hadn’t looked that closely at them up until now.
As of right now, the signs that this is going to lead to a 2008-like financial contagion are low. (Though there are still plenty of risks that a recession or a real-estate meltdown could happen). Dimon, on his call with analysts this morning, said that JPMorgan would curtail some lending after taking on First Republic. The Fed is almost certainly going to raise interest rates by another quarter point tomorrow, and even if it does nothing after that, that can still wreak havoc on the economy in quiet ways. Now that this stage of the crisis is over, it’s worth it to ask: How many more of these failures can the system take?
A previous version of this story said that principal payments are the largest part of monthly mortgage payments. That depends on a number of factors, but it isn’t always true, so the reference was removed.
