If another bank bought First Republic for a single dollar, it could still end up costing that buyer tens of billions.
For many years, First Republic had a sterling reputation as a fast-growth lender focused on a very desirable clientele -- the affluent. One might think that such a franchise would fit well with any number of banks looking to grow businesses like wealth management. Its assets are also seemingly mostly solid ones, like government securities and mortgages extended to those well-off clients. Yet with the bank's market value now hovering at around $1 billion, down about 95% from the start of the year, no buyer has emerged.
While First Republic might hope to work through its crisis over time, waiting for its bonds and loans to mature or repay in full, an acquirer wouldn't have that luxury. Under merger accounting rules, a buyer would have to immediately mark down the assets it is acquiring to fair value.
In its first-quarter report, the bank didn't give updates on the fair-value estimate of its assets. So it is likely these values have improved somewhat, as government bond yields fell over the first three months of this year. But as of the end of last year, it was sitting on paper losses in its held-to-maturity securities of about $4.8 billion.
In addition, the fair value of its real-estate-secured loans was about $19 billion below their carrying value. Many of these mortgages are paying a fixed rate, either indefinitely or for the next few years, at what are now relatively low interest rates.
Even if those mark-to-market losses were now a few billion less, and after adjusting for tax benefits of the losses, needed write-downs might still effectively cancel out the bank's shareholder equity, which was around $18 billion at the end of the first quarter. This means that the buyer would have to put up billions of capital just to keep its own capital ratios compliant with regulatory minimums as it adds assets to its balance sheet.
"It might cost you $30 billion of capital to buy the bank for free," says Autonomous Research analyst David Smith.
In a typical bank deal, an acquirer can count on intangible assets to offset those hits to the values of bonds and loans. For example, acquirers often recognize some additional value for the acquired bank's deposits, which in contrast to its assets might be worth more than they appear on paper because they are cheap or stable. Given its deposit woes, it is hard to say what that value might be for First Republic. Plus, intangible assets like this don't count toward the regulatory capital needed to run the bank.
There are some possible offsets. A bank that buys the assets at fair value might then quickly sell them to pay down expensive government borrowing or to cover the return of big banks' emergency $30 billion in unsecured deposits. That would reduce the bank's size and capital needs. The acquirer could also benefit over time as the acquired assets rise in value or pay off.
But the tricky math for an acquirer might help explain the current state of affairs, in which First Republic plans to restructure its business. One other plan under consideration, to have a group of banks buy assets from First Republic at above-market prices, could effectively socialize the costs of acquisition that would otherwise be borne by one buyer. This might be one reason for banks to hesitate in helping out now, for fear it would only allow an ultimate buyer of First Republic to get a far better deal. But getting a form of equity as part of the deal would help the group of banks all benefit in that scenario.
If that can't be worked out, an alternative form of a full acquisition might be a government-arranged sale in which the acquirer gets a federal backstop for its losses.
When something can't be sold even free, sweeteners need to be thrown in. One way or another, someone has to pay.