FRC - Never Waste A Crisis: JPMorgan Gets First Republic In A Deal To Expand High Net Worth Business

2023-05-01 12:11:04 ET

Summary

• JPMorgan won the rushed auction to acquire First Republic and prevent another messy bank failure after First Republic experienced a fatal level of deposit outflows and a mismatched balance sheet.
• JPMorgan is acquiring loans and securities from First Republic at a meaningful discount to their accounting value, driving immediate tangible book accretion.
• Like the SVB deal, the FDIC is providing loss-sharing agreements on the loan book and low-cost fixed-rate financing to facilitate the deal.
• Acquiring First Republic could be an invaluable boost to JPMorgan's efforts to grow its asset management and high net worth businesses, but maintaining those relationships is critical and not guaranteed.
• Even with less-than-perfect post-deal integration, this is a good deal for JPMorgan, and I believe the shares are undervalued below $160.

It's not necessarily true that strong companies get stronger through tough times, but I believe it's true that part of what defines a "well-run company" is management's ability to seize opportunities that come along during those hard times. I've long expressed my view that JPMorgan ( JPM ) is among the best-run banks in the world, and I believe the opportunistic and accretive acquisition of First Republic ( FRC ) is consistent with that viewpoint and again highlights the value of having a "fortress" balance sheet that can be deployed to grow the business.

I don't see meaningful risk in the First Republic deal from a credit perspective - First Republic had liquidity and duration management problems, not credit problems - but I do still see some challenges with this deal. Retaining First Republic's valuable relationship managers and high net worth (or HNW) customer relationships may prove more challenging than expected, reducing some of the long-term value of the deal. I also believe there will be some backlash to this deal from politicians looking to score points on the idea that large banks already have too much power and scale.

At the bottom line, though, I like this deal and continue to like JPMorgan as an all-weather option in the banking sector.

The Deal

First Republic effectively raised the white flag and lit the fuse on its own demise when it reported first quarter results on April 24, 2023. The results made for grim reading, including a 58% quarter-over-quarter decline in core deposits (excluding $30B deposited by a consortium of large banks, including JPMorgan). But I believe it was the lack of Q-&-A for the earnings call, the lack of a clear turnaround plan, and the announcement of a significant workforce reduction that signaled the end - with relationship managers and HNW clients already leaving, and a clear need to shrink the balance sheet. The writing was on the wall.

Hoping to avoid a messy failure/seizure process, the FDIC solicited bids for First Republic. Three large banks (JPMorgan, PNC ( PNC ), and Citizens ( CFG )) reportedly submitted bids, with JPMorgan chosen as the winner of the process. As there's often little-to-no transparency into these proceedings (stay tuned for the potential of a Congressional hearing/investigation, though…), I can't say why JPMorgan was chosen - it's possible they offered the best bid in absolute financial terms, but it's also possible that JPMorgan's ability to absorb First Republic's business with minimal threat to capital played a role.

In any case, JPMorgan is effectively acquiring $18B in net assets for $10.6B (or a little less than $17B in tangible net assets). JPMorgan is taking on $173B in loans ($150.3B after a 13% loan mark that accounts for the below-market rates on those loans) and $30B in securities, and JPMorgan is getting a loss-share agreement with the FDIC that will cover 80% of credit losses over the next seven years for the residential mortgages and the next five years for the commercial loan portfolio. These loans are equivalent to about 15% of JPMorgan's quarter-end loan book, and it's worth noting that those markdowns can be recaptured if the loans are held to maturity.

On the liability side, JPMorgan is getting $92B in deposits and $28B in FHLB deposits. JPMorgan will be repaying $25B of deposits provided by that consortium of large bank to stabilize First Republic and also eliminating their own $5B contribution. I think it's worth noting that another $12B or so of deposits ran out of the bank in the short time between First Republic's earnings announcement and this deal.

As part of the deal, the FDIC will be providing a $50B five-year fixed-rate financing facility to JPMorgan. Management was asked about the rate and declined to answer. First Citizens ( FCNCA ) ( OTCPK:FCNCB ) got a 3.5% rate with its five-year $34.6B note from the FDIC to assist with the SVB takeover, so I would think JPMorgan's rate could be in that ballpark.

What JPMorgan Is Getting

Right off the bat, JPMorgan is getting earnings and tangible book accretion from this deal - management guided to around $0.17/share (or around 1%) of first-year accretion, and an internal rate of return in excess of 20% on the deal. The bank also is getting a significant boost to its wealth management and HNW business, adding scale on both the West and East coasts.

How accretive this deal will prove to be for JPMorgan over the longer term is a harder call. A lot depends upon how well JPMorgan can integrate and maintain/retain the remaining First Republic business, but there are some challenges here.

First, First Republic already announced a 20%-25% headcount reduction plan, but apparently about 10% of its relationship management teams (representing around 20% of AUM) had already left. This is a relationship-driven business that emphasized long-term personal relationships between managers and clients (First Republic HNW clients would have the same relationship manager/team for years and years). Many of these managers may well not want to work for a banking behemoth, and it may require significant effort (and financial incentives) on JPMorgan's part to keep them.

Likewise, many of First Republic's HNW clients may not wish to do business with JPMorgan, and it will be challenging to strike a balance between maximizing client service and maximizing the profitability of the business. For instance, one of the benefits to being a First Republic client was that the bank was willing and able to make very quick decisions on very large mortgage loans - but with JPMorgan wanting to scale back the jumbo mortgage franchise at First Republic, can they thread that needle of offering HNW clients enough of what they want to stick with the bank?

So too with the commercial business. First Republic was likely going to shrink its balance sheet in part by executing on its rights to call loans (at par) that had underlying deposit requirements - in other words, some of the depositors that pulled their money from First Republic were technically in violation of their loan agreements and First Republic had/has the right to demand repayment. Whether JPMorgan will choose to pull those triggers (and/or whether those borrowers will choose to re-deposit their money) remains to be seen.

If JPMorgan can keep the majority of First Republic's most productive relationship managers on side, and if JPMorgan can reassure HNW and business clients that they will maintain the high levels of service and responsiveness to which they're accustomed, this will be a major boost to JPMorgan's stated goal of expanding its HNW business. If they cannot, and it will be a challenge, then a lot of the long-term strategic value of the deal (as opposed to the "net assets versus purchase price" value) will erode.

The Bottom Line

I believe JPMorgan is going to see employee and relationship attrition from First Republic, but not so much that it makes this a bad deal. The structure of this deal leads me to believe it's a very low-risk opportunity, and I think JPMorgan understands the nature of the business they're buying and will put in the effort (and resources) needed to preserve the value of the First Republic franchise.

I still expect mid-single-digit long-term core earnings growth from JPMorgan, and I believe this deal is a pretty classic case of the rich getting richer. Although the near-term profitability outlook for banks in general is weaker now (higher deposit costs, weaker loan growth, higher operating costs, etc), I believe JPMorgan offers a good combination of growth, value and risk and I believe the shares are undervalued below $160.

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