Requiem for a bank loan

Patrick McKenzie (patio11)
Requiem for a bank loan

The slow-motion banking crisis we’ve covered for the past several issues of Bits about Money is slightly awkward for me to talk about, for social reasons. I decided to lean into the awkwardness a bit this time.

(Hopefully we’ll be back next time on non-banking topics. To the extent the U.S. banking system is solvent and boring there should be more interesting things available to write about! It is only when large portions are suddenly insolvent does it become irresistibly interesting.)

There are two general sources of awkwardness when writing about banks: one, the industry guards its reputation very zealously. Surprisingly small mentions of individual firms can bounce around enough to reach people professionally relevant to me. (As always, while I am a past employee and current advisor at Stripe, it does not necessarily endorse what I write in my personal spaces.)

Two, I am inclined to scrupulosity in disclosing relationships when writing about firms. No one anywhere seriously expects a conflict-of-interest disclosure over a checking account, but once one is talking about e.g. mortgage-sized sums, you have to at least think about it.

And so I have a relationship which I’d like to disclose, which is actually a jumping off point into a wider discussion of things misunderstood about the recent (and ongoing) crisis.

First Republic’s Personal Line of Credit

One of the best products offered in the U.S. financial industry the last few years, and broadly underappreciated, was First Republic’s personal line of credit. (The division of Chase currently operating as First Republic has a product named the same thing as of this writing and it is not materially the same product for reasons we will soon discuss. The Information reported recently that First Republic is quietly sunsetting this business.)

Their publicly generally available offer was an unsecured signature loan for up to (generally) $100,000. It had a 2 year draw period, during which one would pay interest only, then amortization over the remainder of the pre-chosen lifetime for a total of 7, 10, and 15 years. There was no penalty for early repayment, not that repaying early would have been a good idea.

That’s already a combination of attributes you would not find many banks offering. Now here’s the kicker: it was, until the recent failure of First Republic, written in quantity at a sweetheart interest rate.

How sweetheart? Well, as of early 2021 (for an example we’ll return to), you could get a 7 year fixed rate of 2.25%. (This was net of discounts, which we’ll return to.)

This was ludicrously favorable and that was an intentional strategy. We’ll talk about the strategy more in a moment.

In which I unexpectedly found myself in San Francisco

First Republic would only write loans within their branch footprint, which (to simplify slightly) is “the parts of the United States most densely populated with high net worth people.” I have lived almost all of my adult life in Japan, and so could not take advantage of this. (Japanese banks, despite the prevailing interest environment, are markedly less likely to write unsecured consumer loans at low interest rates, for a variety of reasons.)

Then mid-pandemic I suddenly found myself running a non-profit (best known as VaccinateCA) which ran the United State’s covid vaccine location information infrastructure. It is a somewhat wild story, and I’ve told it before elsewhere.

In the very early days of that effort, knowing that I couldn’t survive continuing to work from midnight to midafternoon and that official California would eventually react with extreme displeasure to being puppeted by a geek in Tokyo, I bought a one-way ticket to San Francisco. I told my wife and kids I’d be back either in a few weeks in the case of failure or much later in the case of success. It ended up being about 5 months.

One of my main jobs for VaccinateCA was stumping for money. Concurrently with raising money for the charity, I also needed it for us, because maintaining a second household in San Francisco is not a cheap proposition and I was temporarily on leave from my employer. I didn’t want to complicate fundraising discussions with my own situation, so VaccinateCA paid me $1 and I absorbed personal costs by shattering the (metaphorical!) piggy bank.

Here I’ll acknowledge some residual middle class guilt for talking straightforwardly about finances, but I think it’s useful to understand both for this story and for the larger issue of understanding the banking system.

(The banking system must, of course, frequently process transactions which are larger than various comfort levels. The class norm of not talking about money silos the information about those transactions, to the detriment of both class members and also the wider public. This has been replete in discussions of the banking crisis. Many commentators react in mock horror to discussions of accounts with more than the FDIC insurance limit in them, as if that didn't include almost every company with more than 10 employees in the country.)

So, the awkwardness: the piggy bank had about $100,000 in it. This seemed like a dicey amount for an open-ended commitment with functionally no income while supporting two households in high-cost cities.

Now I could have gotten creative in financing personal expenses, but I preferred spending almost all of my time on VaccinateCA. So I had a brief negotiation with First Republic, where I asked for (and got) a $100,000 credit line “for cash management purposes.” My recollection is that this took less than two hours total, inclusive of time to write the loan application.

I was not raised to be enthusiastic of debt, but inking that credit link was an enormous relief for me. It meant that I could almost ignore my family’s personal financial situation for the duration of VaccinateCA.

I eventually drew all of it. (To make a long story short: our charity raised from a variety of tech industry funders, frequently with a substantial lag between verbal commitment and receipt of the wire. We were operating at a cadence much faster than most funders. When we received a commitment to funding, I sometimes advanced money to the charity with the intent of recouping it after the donation had actually arrived. This was to accelerate shots into arms, our sole goal. After we had operated for a few months, the funding environment changed in a fashion that made not all promised grants actually arrive. In lieu of causing the charity to shutter early, I recharacterized my loan to it as a donation, and the marginal cash saved paid salaries and expenses in our final weeks. This ended up being $100k out of the $1.2 million we raised.)

The fundamental purpose of bank loans is to enable measured private risk-taking by leveraging a small amount of bank equity (from risk-taking investors) with a larger amount of risk-adverse deposits. Sometimes the risks are opening a restaurant or buying an apartment building in an up-and-coming neighborhood; here the risk was a crash project to build charitable medical infrastructure during a crisis.

Risk is not a four-letter word. Society wants restaurants, apartment buildings, and crash projects to build charitable medical infrastructure. The banking system enables a higher rate of creation of these goods than would prevail in an environment where only risk capital was available to fund them. This is its main social purpose; the checking accounts and payments infrastructure and tastefully decorated branches and bonus checks are all consequences of it.

Society should be thrilled it has banks, like it should be thrilled it has power plants. The alternative is a far worse world.

So you’re a bank underwriter

Let’s play the world’s most boring game of Dungeons and Dragons: pretend you are sitting on First Republic’s credit committee. What do you need to see in a loan application packet to underwrite this loan?

Well, you need KYC information, clearly. That’s straightforward; you had a U.S. passport passed over a counter at a branch. It matches an existing U.S. credit profile, which both solidifies your KYC story and also answers most of your worries about credit risk.

Underwriters would traditionally ask about capacity to repay, and while this product was offered on sweetheart terms, it was underwritten reasonably rigorously. Two discounts offered to the rate were contingent on depositing 10%-20% of the line of credit amount in a First Republic checking account. This both directly decreases risk via acting similar to collateral and indirectly decreases risk because most people who are poor credit risks can’t come up with $20,000 in cash.

Now you turn to the income story. Here is where most bank underwriters would have noped the heck out: my documented prior income was “weird” by the standards of U.S. banks. It wasn’t W-2 and was denominated in yen. (W-2 is the U.S. tax form issued by employers to document wage income, and one’s “W-2 income” is the most legible form of income for the U.S. financial system. All other forms of income, of which there are many, are harder to underwrite to.)

One thing which First Republic historically did very well was parsing certain varieties of “weird.” I was pleasantly surprised to see that the loan application anticipated partially international transactions; there were pages of the workflow dedicated to that. This was not their first rodeo.

An aside: You’d be surprised how many U.S. banks, of all sizes, are completely incapable of dealing with this as a matter of procedure. As a consequence, they have large lines of business utterly incapable of touching anyone who needs to present non-U.S. dealings in their file. Banks with incompetence regarding mobile people include, strikingly, many which have substantial international operations in capital markets and commercial banking. The biggest banks in the U.S. brag se habla español and then are utterly befuddled that immigrants exist, leaving the Spanish-speaking ones to Seis (a small angel investment of mine). Anyhow, back to the more functional bits of banking.

Underwriters aren’t concerned with past income, per se. They want it as a proxy for future income, and therefore future ability to repay the loan. And here, First Republic was simply willing to stretch a little for a desirable customer. Sure, my immediate future looked upside-down financially, but they believed my mid-to-long-term career prospects were fairly good, and were willing to go along for the ride. (One might sensibly wonder “Did your balance sheet make any difference?” and the answer was a resounding “Nope.” They were utterly uninterested in e.g. private tech equity, on a “Don’t even show us the docs we will not count it in your favor for this product” level.)

Why did First Republic stretch here? Was it due to a one-off exception? Not having been at the credit committee’s meeting, I can only speculate, but I speculate that this was rubber stamped as being clearly within the parameters of this product. I had a somewhat-higher-than-typical degree of weirdness in my application but the product was designed to attract the business of people who’d routinely have weirdness like e.g. working at a startup they founded, earning most of their income via carried interest and not on a W-2, etc.

Successful Millennial Generation Strategies

Sometimes companies do other-than-straightforward things for strategic reasons. This is often the cause of a lot of external speculation, sometimes verging on conspiracy theorizing.

It is underappreciated that publicly traded companies will frequently write down their strategies, explicitly and at substantial length. And so we don’t have to speculate why First Republic offered sweetheart deals on lines of credit.

Per their 2021 annual report (emphasis added):

Our next-generation client strategy continues to be highly successful. Drawn by our Personal Line of Credit, Professional Loan and affiliate programs, younger client households grew 14% during 2021. We’re attracting younger urban professional households even earlier in their careers. This strategic initiative is intended to engage younger clients with specific products to spur trial and subsequently build deep, lasting relationships. It’s been transformational at First Republic. At year-end, millennial households represented over 40% of First Republic’s total consumer borrowing households, compared to only 12% in 2015.

First Republic talked this product up to investors, regulators, and other stakeholders for years. (The heading for this section is stolen from their quarterly reports; they recycled it frequently.)

They had a structural problem common in the banking industry: a commanding share of their deposits were held by retirees. (It is broadly underappreciated how much wealth in the U.S. is held by seniors, almost entirely due to lifecycle factors.) The typical behavior of older households is to spend down their savings. The bank would be inconvenienced if it saw large deposit outflows (oh howdy was it aware of that risk), and so it made a bet intended to pay off in decades: get young millennial professionals early, in their pre-rich years, and then hug them tightly for life.

Interestingly, due to banking regulations, you’re not actually allowed to say This Loan Is For Young Professionals because age is a protected class. You’d have to go very far into the archives to find this loan explicitly referred to as being for young professionals in the marketing material. Compliance eventually read it and (one presumes) gave Marketing a non-recorded phone call whose contents are very predictable. So strategically, the loan program was designed to generate additional business from young professionals, even if the bank underwrote individual loan applicants without regard to age.

A brief digression about permissible and impermissible discrimination in lending: I have no reason to believe the bank actually discriminated on age, at least outside the socially-accepted way of discriminating against FICO scores that incorporate time-credit-profile-has-existed, which reliably disadvantage the young by proxy. To the extent we say age is a protected class, anyway, in U.S. practice this broadly means the old are protected against the young but not vice versa. (Surprised? See page six.)

This line of credit grew out of an earlier program, where First Republic offered it explicitly for debt refinance. The basic sketch of that was “You’ve spent a lot of money on education and now made it into a high-earning job; refinance your education with us at a sweetheart rate and we capture your deposit business in return.” By 2020 that was so successful it expanded into lines of credit, which didn’t merely capture backwards-looking debt but could potentially fund forward-looking expenditures.

Building the deposit franchise

The goal of this loan program was to function as a loss-leader for the deposit franchise. First Republic’s business model was to charge richly for providing good banking services to well-off customers.

(For a combination of culture-of-banking and regulatory reasons, it was open to the general public. Almost anyone could have opened an account there with $25. But the core of their business, to a much larger degree than most banks, was high net worth households and the relatively small organizations they run. Their typical business client only had a few hundred thousand dollars on deposit; it was someone's local charity or small business, not a large enterprise.)

They paid their customers almost nothing on their deposits (0.40% in 2022, up rapidly from 0.07% in 2021), lent them back out to the same customers for more-than-nothing, and ran a very profitable business for many years.

They didn’t expect to lose money, per se, on lines of credit. The normal usage of “loss leader” is to describe supermarkets’ practice of pricing certain high salience items (e.g. milk) at much tighter unit margins than they price most of the store at. This doesn’t mean that they necessarily lose money on each gallon of milk they sell, though negative unit margins occasionally happen in the world.

First Republic expected nearly zero credit losses in this program and they were right about this expectation. They used to quote a total number of individuals who were presently late in their quarterly presentations and you could count to it on one hand. If you wanted the feeling of rigor, you could go to the crunchy part of the credit quality analysis and see that on $3 billion in outstanding unsecured loans (of which this program was a subset) they had $1 million in loans which were 30-60 days late and no defaults whatsoever.

First Republic additionally bragged that the households attracted by their Successful Millennial Generation Strategies™ were largely self-funding. The strategy was designed to pay off over a period of decades but was on track to outperform plan. In a period of mere years it had already gone from (effectively) their older, wealthier depositors subsidizing acquisition of younger, less wealthy customers to being internally self-sustaining. Accounts of slightly older millennials were already bringing in enough deposits to almost cover the loans of slightly newer vintage households.

How did that happen?

For one thing, these were lines of credit, rather than loans. A line of credit can be attractive in option value terms without actually being drawn upon. If you incentivize AppAmaGooBookSoft employees to move their core checking accounts to you by offering them sweetheart rates if they ever need it, many will take you up on that without ever needing it.

For another, the terms of the lines themselves incentivized partial coverage of loans by the borrowers themselves. Interestingly, this was more on a handshake than a contractual basis. My paperwork quoted a 0.50% interest reduction for maintaining at least a 10% of the line ($10,000) deposit average and 0.75% total for 20% ($20,000).

For, as best I can determine, operational or software reasons, First Republic wasn’t actually capable of dynamically altering the loan rate every month in response to one’s actual savings behavior. They just assumed you’d keep to the handshake, wrote the final interest rate into the contract and loan servicing database, and charged you that regardless of your balance every month.

And for a third, this product was designed to (and successfully did) attract high-earners during a period of their lifecycle where they would, in expectation, go from having almost no assets to having substantial liquid wealth and a large paycheck arriving every two weeks. The modal newly hired tech employee in San Francisco who owns no mattress frame and needs an account for their first paycheck will not have zero dollars in that account in five years.

I recall a funny conversation during my account opening, which is an almost-too-good-to-be-true window into the socioeconomic weirdness that is being a young professional in tech. The banker assisting me asked how much I wanted to open the checking account with.

Me: “I think a hundred.” (As we had already been discussing the line of credit offering and my rationale for seeking it, I assumed this was unambiguous.)

Him: “For clarity, do you mean a hundred… dollars? Or…”

Me: “Oh, no, sorry. A hundred thousand dollars.”

Him: “I’m glad I asked. We’re running a promotion for new checking accounts, and…”

Me: “Ah yeah, it’s a funny thing in this town that it could have been a hundred or a hundred thousand.”

Him: “Oh, you wouldn’t be the first to mean the other hundred.”

All of those are plausible for a lanky San Franciscan who shows up to open a checking account while wearing a track jacket. Some portion of those new relationships will prosper, and the bank prospers with them.

First Republic took substantial losses on these (and other) loans

During the initial phase of the banking panic, people concentrated on large losses in banks’ portfolios of marketable securities, partially Treasuries but mostly mortgage backed securities. Tsk tsk, bank risk managers, why are you speculating on interest rates and not performing the traditional function of banking, making solid loans backed by strong credit?

First Republic is no longer with us not because of losses on their available-for-sale or held-to-maturity securities but rather because of large losses on their loan books. The overwhelming majority of them were on fixed rate mortgages secured by primary residences in places like New York and San Francisco. That was many tens of billions; these loans were only a handful of billions.

Here it is useful to point out that bond math applies to loans in addition to bonds: a 1% increase in prevailing interest rates decreases the value of the loan by approximately 1% per year of duration.

As a worked example, the line of credit I signed from early 2021 has approximately 2.5 years of duration still on it. (I will be paying it for five more years, the average amount for those 5 years is half of the current total, etc.) Interest rates rose by about 5%. And so First Republic took more than a $10,000 paper loss on my business.

I’m still paying! I still bank there! My financial situation has improved markedly since I opened my account! Everything is going exactly according to plan! And yet, when replicated across their loan book, that evaporated many tens of billions of dollars of equity.

This would have been survivable had they not suffered $100 billion in deposit flight, in the early stages of the banking crisis.

When Chase bought First Republic, they effectively received an inducement from the FDIC to cover the “pain” of buying loans (new assets of Chase) which had decreased in value at the same time as they absorbed deposits (new liabilities of Chase) which had not decreased in value. The total cost of those inducements was estimated by the FDIC at $13 billion. With respect to me specifically, I think they got about $10,000. Not bad work if you can get it.

(Here I’ll make the obligatory disclaimer that I’ve been a Chase customer for a very long time. Without going into inappropriate levels of detail, let's say that they have richly earned me performing exactly to contract.)

The broader picture

Every time a firm goes out of business unexpectedly, a tiny bit of light goes out of the world. I mourn a bit for First Republic, much like I mourn the local barbecue joint that couldn't make Tokyo rents during the pandemic.

It is likely that the customer service attitude and risk taking culture that was distinct to First Republic will eventually be fully subsumed into the Chase borg.  Should we, as a society, be happy about that? It is probably the least worst option we had in 2023, contingent on a fiscal response to the pandemic which broke large portions of the banking sector.

It has been quite popular for various parties to point the fingers at bank management teams, saying that impressively impecunious operation of the core business of banking is the proximate cause for the crisis. The crisis is caused by the pace of change in interest rates. Everything else is commentary.

There are many more good banks out there, which were and are in what I’ve called the sweat and smiles business. They made good loans to good borrowers, taking limited risk in the service of encouraging private risk-taking.

Those banks are dead as a result. Academics estimate that there are thousands of them. Almost all of them are still shambling around, like well-dressed extras on the Walking Dead.

The current social consensus is that we presently expect most to limp their way out of the crisis. I think the consensus underrates the need to recapitalize the banking sector, to the tune of several hundred billion dollars.

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I write about the intersection of tech and finance, approximately biweekly. It's free.