What First Republic’s Failure Means For The Economy

Just when investors thought that stress in the financial sector was finally subsiding, they woke up to a bombshell on Monday morning.

What just happened?

First Republic was shut down overnight by the Federal Deposit Insurance Corporation (FDIC), wiping out shareholders in the second-biggest bank failure in American history. To be fair, this shocker didn’t just happen out of the blue: First Republic had been on the verge of collapse for almost two months, and recent private rescue efforts to fill the hole in the troubled lender’s balance sheet led nowhere. All of this comes after deposits plunged by more than $100 billion last quarter, after the bank’s business model of providing cheap mortgages to affluent customers was pressured by sharply rising interest rates. Those higher rates also pushed up the bank’s funding costs and led to huge paper losses on its portfolio of mortgages and other long-term assets.

First Republic is the third (and biggest) lender to be shut by the FDIC in less than two months. Silicon Valley Bank and Signature Bank were taken over by regulators and sold seven weeks ago, after higher interest rates left the banks nursing heavy paper losses on their assets, all while depositors yanked out their cash.

There’s one beneficiary from the latest episode of turmoil though: JPMorgan, which won the bidding to acquire First Republic’s assets, including about $173 billion of loans and $30 billion of securities, as well as $92 billion in deposits. The transaction is expected to generate more than $500 million of incremental net income a year, the company estimated, and will make JPMorgan – already the US’s biggest bank – even more massive. JPMorgan’s size and existing share of the US deposit base would have prevented it under normal circumstances from expanding its deposit base further via an acquisition. But these are far from normal times, and regulators made an exception.

What’s the wider impact here?

Well, it’ll most probably accelerate the withdrawal of credit, which is the lifeblood of the economy. Tightening credit standards cause consumer spending and business investment to plunge, which derails economic growth. And as I explained last week, the lending environment was already deteriorating even before the most recent spree of turmoil in the banking sector. The latest episode of stress, then, will only intensify things: worsening credit conditions as banks tighten their lending standards in a bid to strengthen their balance sheets – in the end increasing the odds of a recession.

Against this backdrop, you might want to exercise caution with your portfolio by making sure it’s well-diversified. You may also want to consider reducing your risk, avoiding leverage, holding cash, investing in gold and long-term government bonds, and tilting your stock exposure toward defensive sectors.