Dear readers,
As I discussed in my first article on this blog, the Fed has a tough job to try balancing the economy, interest rates, inflation, and defaults. We are bound to see more surprises coming our way. As we speak, yesterday, we saw another major bank collapse in the US – First Republic Bank. It got bailed out by JP Morgan Chase and FDIC.
To understand the magnitude, First Republic Bank was the 14th largest bank in the USA, with approximately $230 billion in total assets. The bank was larger than HDFC Bank in India. Within the last two months, we have witnessed 3 of the 5 biggest bank failures in the USA, even after adjusting for inflation. Quite something!
Here is a graphic representation of the same:
Source: Investopedia, FDIC
First Republic Bailout – A Sweet Deal for JP Morgan Chase Bank
The devil is in the details. Let us take a closer look at the deal details of the bailout. When I think about this deal's second and third-order impact, it throws up some interesting insights.
Firstly, the transaction details:
Source: JP Morgan Chase & Co. Presentation
As you can see in the above snapshot, JPMC is effectively paying $10 bn for $200 bn+ worth of assets and about $18 bn Net Equity (Cents for dollars). That is not all. FDIC will also be covering 80% of losses for seven years on mortgages and another 80% loss coverage for five years on commercial loans!
JP Morgan also will not assume any of the First Republic Bank's corporate debt or preferred stock. JP Morgan will post a one-time post-tax gain of approximately $2.6 billion. According to their estimates, this deal will add $500 million in incremental net income every year with an IRR of 20%+.
It is a good deal for JP Morgan, but it is detrimental in every way for the banking sector, particularly the smaller banks in the US. Here is why:
1. The Big gets bigger
This is unanimously and undoubtedly a great deal for JP Morgan. The interesting part here is that, according to the Riegle-Neal Act of 1994, there is a restriction on making acquisitions for banks with more than 10% of overall system deposits. JP Morgan falls in this bracket, yet here we are, with JP Morgan Chase bailing out and acquiring all the assets of First Republic Bank. It seems like a last-resort action more than anything else.
2. Trouble in Mortgage and Commercial assets
It 8s interesting to note that JP Morgan Chase is getting FDIC to cover losses up to 80% for residential mortgages and commercial loans for 7 and 5 years respectively. I feel it is indicating that both these segments are in significant distress. The commercial office segment has concerns with high vacancy rates and liquidity crunch. Adding to it is the fact that more than half of $2.9 trillion in commercial mortgages will be refinanced at higher rates by 2025. Almost 80% of these loans are held by small and regional banks in the US. Thus, they are going to face significant pressure to maintain solvency.
3. Third-order impact on small and regional banks
The deposits in big banks in the US are fully insured by FDIC whereas, for the small and regional banks, the FDIC insurance has a limit of $250000. Add to this, the recent bank failures of three important regional banks, and industry deposit rates in the US stilllagging way behind the yield on the Government Treasury Bills, in my opinion do not bode well have smaller banks. I do expect deposit growth to slow down significantly for other small and regional banks in the coming months. When we amplify it with a significant number of depositors taking away the deposits at the same time, we have what we call a "Bank Run".
The data also seems to be pointing out that raising deposits is becoming difficult for the banks given the high yields in treasuries and also with Apple now offering up to 4% on savings accounts.
The below chart of the total deposits in the USA shows that 2022-2023 will be the first time we witness deposit degrowth (deposit growth stood at -2.3% Y-o-Y for Feb 2023).
Source: CEIC Data
Also, if you see the JPMC bailout deal of First Republic closely, JPMC will not be paying any money to the preferred shareholders and the bondholders of First Republic Bank. Now I ask myself as an investor why would I even buy fixed-income bonds of these small and regional banks when there is such a huge risk on my capital? Banking is the business of moving money. These small banks will find it even more difficult and costly to raise new capital in the market, ultimately reducing their balance sheet.
These are my initial thoughts about the deal and its impact. Overall, yes, a great deal for JPMC but I feel it does not bode well for the larger banking sector in the USA.
Interesting times ahead!
The Federal Reserve must take a call tomorrow (May 3, 2023) concerning interest rates. If they do increase rates further to counter inflation -their primary objective, it will make it inevitable for further bank runs in the country. On the other hand, they can try to control the bank runs by stopping rate hikes and letting inflation soar over the longer term, which again will be detrimental.
Source: Fidelity
Another interesting chart (above) that I came across today was that the yield curve (difference between 10 Year Yield and 3 Month yield on Government securities) is inverted to its deepest point in at least the last few decades, while at the same time if you take the differential between 10-year yield and 3 Month Bank deposits, we are looking at a very steep yield curve. The reason is that the bank deposit rates in the US have not caught up at all with the Fed Funds Rate. Either the Fed has to start cutting rates, or the banks have to start increasing deposit rates going further, either way, you look at it, the impact does not paint a pretty picture at all atleast business wise. Valuation wise, we will have to take a look separately.
Historically, the US markets have mostly bottomed out only after the US entered a recessionary phase, not before that. So, it will be crucial to watch out for these developing situations.
I hope you found this read helpful. Have a great week ahead!
Warm Regards,
Shivam Jain
Disclosure: I’m not a SEBI Registered Investment Advisor. All content on this website is purely for educational purposes. Please consult your financial advisor before making any decision.
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