Why First Republic Failed

First Republic's recent failure has come as a shock to many in the financial industry. It is the second-largest bank failure in history after Washington Mutual, which failed during the 2008-2009 Financial Crisis, and has left many wondering what went wrong. In this post, we will unpack what happened to First Republic, how this is the third bank failure we've seen recently, how it could impact other banks, and what that might mean for the future of banking.

About First Republic Bank

First Republic specialized in providing high-quality services to wealthy clients, offering them, among other things, low-interest rates on mortgages. Often these loans were interest only jumbo loans, which are portfolio mortgages that are different than a traditional Fannie Mae/Freddie Mac conventional loan. As a result they had to hold these mortgages on their balance sheet, which is different than a conventional mortgage, where the bank offloads the risk to Fannie/Freddie, and gets their capital back to loan it out to someone new.

They funded almost all of their long-term loans with short-term deposits; extra cash that all of those high net worth individuals had. Because of the makeup of their client base, a lot of those deposits sat over the $250,000 FDIC limit. Those folks with more than $250,000 in the bank tend to start to get a little nervous at signs of bank distress, because they are in a position where they could have deposits not covered by the FDIC if the bank goes under. For First Republic in fact, 68% of their deposits were uninsured, and over the $250,000 limit as of the end of 2022.

Low Rates

To compound the problem, they were paying very low interest rates on that cash over many years as the Federal Reserve kept short term interest rates at essentially zero. When the Fed started to raise rates aggressively that meant that those folks with large cash balances now had the ability to earn substantially more from their cash by taking it elsewhere.

For First Republic this became a major problem because customers had daily liquidity on these deposits, meaning that they could pull their money out anytime they wanted. On the other hand, First Republic was locked in long term on the rates they were earning from their portfolio of mortgages. It’s not like the bank could go back to their mortgage customers and say, "Hey, guess what - interest rates went up, and I know we gave you that fixed rate, but we're going to need you to pay a little bit more because we're kind of getting into trouble." Fixed rate loans just don’t work like that. As a result, First Republic saw their spread – the money they earned on the loans minus what they paid out on deposits start to disappear. To top it off, they also couldn’t sell those mortgages on the open market to raise cash without creating a loss. Think about it – who would pay full price to buy a mortgage where they would earn 3% interest, in a world with 6% mortgage rates. This meant that First Republic was essentially stuck with below market assets, with limited ways to try to get back in the black.

March 2023

Fast forward to March of 2023. The Federal Reserve had been steadily raising interest rates, and all of a sudden storm clouds were forming over the banking industry. When the first two banks failed in March 2023 people started digging around and realized that First Republic had a lot of short-term cash that they had lent out on long-term mortgages and that those mortgages were locked in at below-market interest rates. This meant that First Republic was at a higher risk than other banks when interest rates went up. This prompted those depositors to start looking for the exit, and for opportunistic stock traders to profit as it started to look like First Republic may falter.

Where do we go from here?

So what does this mean for other banks? There is a well-worn adage that investing long while borrowing short is a path to failure. That is essentially what has happened at this point for the 3 banks that have failed as of this writing. My hunch is that these weren’t the only 3 banks in America doing this in an environment where we had almost 15 years of near zero interest rates. The speed and severity of the Federal Reserve rate hikes have caused these issues, and I wouldn’t be surprised if we find some other banks in a similar situation in the coming months.

Time will tell how quickly banks can reconfigure their balance sheets to avoid potential trouble. How well they are able to do that, combined with what reaction regulators may have to these brewing issues will likely dictate how things progress from here.

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