First Republic has been rescued. It hasn't been saved

Eleven of America's largest banks deposited $30 billion of uninsured cash in First Republic Bank on 16 March, in a deal put together by JPMorgan Chase and Treasury Secretary Janet Yellen. It was hailed as a fine show of private-sector solidarity, meant to restore confidence and protect the San Francisco lender from the contagion that sank SVB. A look at First Republic's balance sheet tells a different story. The money is an emergency bridge over a widening solvency gap. First Republic has been spared a weekend seizure, but its business model still does not add up.

First Republic did not gamble on crypto or venture capital. Its problem came from a cautious, high-touch wealth management strategy, which filled its books with jumbo mortgages to rich clients at fixed rates between 2.5 and 3.0 per cent.

A franchise built for low rates

For two decades the model worked well. First Republic won wealthy clients in San Francisco, New York and Boston with attentive service and cheap mortgages, and in return it collected their large deposit balances, much of which paid little or no interest. When rates were near zero, lending at 3 per cent against funding at almost nothing earned a comfortable spread, and loan losses were tiny because the borrowers were rich.

The weakness was the same client base that made it strong. Wealthy depositors hold balances far above the $250,000 insurance limit, and they read the news. After SVB failed they moved money quickly, and all three large rating agencies cut the bank's credit rating to junk within days, which made other funding harder to find.

Good borrowers, bad rates

These borrowers are excellent credits, but the interest-rate risk is deadly. With mortgage rates above 6.5 per cent, the bank's loans and securities carry more than $25 billion of unrealised losses, a sum that more than wipes out its tangible common equity.

The losses stay out of the headline capital ratios because loans held for investment are carried at their original cost. They surface only in the footnotes that disclose fair value, or when a bank has to sell. That accounting lets First Republic look solvent on paper while a buyer, who would have to value the loans at market prices, would see a large hole.

The Fed's new facility offers little help. The Bank Term Funding Program lends at par only against Treasuries and agency securities, and most of First Republic's losses sit in its mortgage book. Mortgages can be pledged at the discount window, but at a discount to their market value, so the bank gets less cash for every dollar of loans than it needs to replace departing deposits.

The $30 billion from the big banks does nothing to repair that hole. It simply replaces cheap deposits that have fled with short-term wholesale money costing close to 5 per cent.

Paying more than it earns

First Republic now pays more for its money than its assets earn. Its wholesale borrowings and rescue deposits cost 4.5 to 5.0 per cent, while its assets yield on average below 3.5 per cent.

The bank loses money every business day, and its remaining franchise value shrinks with it. Without a buyer backed by the government and willing to take the losses at par, no private investor will put in fresh capital.

The arithmetic is slow but relentless. A negative spread of a percentage point or more across a balance sheet of this size burns capital each quarter, and the losses compound because the bank cannot lend its way out. New mortgages at today's rates would earn a positive margin, but writing them requires funding the bank does not have. Shrinking by selling old loans would crystallise the losses that are now hidden. Every week without a solution also gives the remaining depositors another reason to leave, which forces the bank to swap more cheap funding for dear funding and deepens the loss.

A rescue that failed before

America has seen a private-sector rescue of a large bank fail before. In May 1984, as uninsured depositors pulled money from Continental Illinois, a group of large banks put together a credit line to steady it. The run continued, and within days the FDIC and the Fed had to step in with public money, taking control of the bank and guaranteeing all its depositors and creditors. A show of support from rivals could not fix a balance sheet that the market had already judged.

The same logic applies now. The $30 billion signals that the big banks think First Republic's collapse would hurt them all, but it does not change the value of its assets. If anything, the deposits make the eleven lenders creditors of the bank, with an interest in an orderly exit rather than a disorderly one.

The paths from here

There are only a few ways out, and none is painless. A capital raise would require enormous dilution at a share price that has already lost most of its value, and investors would demand protection against the loan losses. A sale to a larger bank would force the buyer to mark the loans to market, and no buyer is likely to accept that without government help. That leaves an FDIC-led resolution, in which the agency would seize the bank and sell it, probably with some sharing of losses.

In each case the losers are much the same. Common and preferred shareholders would probably lose most or all of their stakes. The rescuing banks would want their deposits protected, and the FDIC's insurance fund, which is refilled by levies on all banks, would bear part of the cost. Borrowers with cheap mortgages would keep them, since their loans would simply move to a new owner.

The signals to watch are the bank's first-quarter results, due later in April, which should disclose how many deposits have left, and the Fed's weekly figures on emergency borrowing. Any sign that talks with potential buyers have stalled would bring the end closer. The $30 billion bought regulators some time, nothing more. A bank whose funding costs more than its assets yield cannot last, and an FDIC takeover within weeks looks likely.