First Republic Bank
Q1 2011 Earnings Call Transcript

Published: 16 Mar 2012

[Ericka Penala:]

I’m Ericka Penala and I’m the regional banking analyst here at Bank of America Merrill Lynch. It is my pleasure to introduce up next Chairman and Chief Executive Officer Jim Herbert of First Republic Bank. Headquartered in San Francisco with $26 billion in assets, First Republic focuses on serving high net worth customers in urban coastal cities on the east and west coast. The bank completed its initial public offering in December 2010 and continues to be one of the fastest growing banks in the industry while offering among the best [inaudible] metrics throughout its life cycle. With that, I’d like to turn the presentation over to Jim.

[James H. Herbert:]

I’m going to go through a slide presentation and I’ll do that fairly quickly and informally hopefully and then we’ll open up for questions. Just to stand back for a second, we started the bank with 10 people, it was de novo in 1985, it was actually an industrial loan company initially not federally insured. We’ve grown ever since but we have focused on high net worth individuals through home mortgage for a long time. Where, as Ericka said, we’re about $27 billion now, we have deposits of $22 billion and importantly, our credit is very clean. We’ve been under 15 basis points. We did sell the bank, we were public in ’86, we sold to Merrill Lynch at the end of ’06, closed in ’07 and that was an interesting experience and we bought the bank back recently successfully. The good news is when we went into Merrill and BofA the deal was struck in a way that kept the bank intact. Basically, that was the idea from the beginning so we were able to buy back quite a clean isolated entity. That’s why we take this approach which is since the end of ’10 but really we bought it back in July of ’10 we’ve had a 15% annualized growth rate and our deposits are growing at 18%. Of course, everybody is having great deposit growth, all of a sudden core deposits are everybody’s long suit but we’ve actually had a long term or come to abnormal long term successful growth rate. We also are a wealth manager. We’ve morphed the bank from mortgages and simplistic deposit products to more deposit products for the high net worth client and then we increased our wealth management offering starting in about 2000. We also came out of San Francisco which is our home market, went down to LA relatively early, San Diego relatively early and then came to New York about 11 years ago, came to Boston about five or six years ago now. So we’re bicoastal, we like urban coastal markets. What is it about us that works? We basically have a very old fashioned but very effective relationship manager single point of contact banking model. Our relationship manager, or the preferred banker, or the portfolio manager if somebody comes in through wealth management, are the point of contact for the client. They deliver the entire bank. We don’t have silos, the whole bank can be delivered by an individual and I’ll give you a couple of examples of that in a minute. We have a dogmatism about credit, we don’t like losing money on credit. We really don’t and the margins don’t allow for it as we all know. So we have had a very low loss experience, our home lending, which is almost $50 billion so far in the history of the bank, 26 years, we’ve had about five basis points of losses. We have a strong balance sheet and we have strong growth. This is really the model, we do nine products per home loan. New home loan is the way we measure it but it may not be a new customer it may be just a new transaction. That comes from the ability – first of all it comes from the needs of the complex clients that we have and it comes from the ability of the single banker to deliver everything and so you have a tremendously strong cross sell experience. The JUMBO home is our lead but it’s not the only thing, we lead with business banking now, and we lead with wealth management as well. It depends on the client, how they find us, how they come in. We have a very strong and complex and overlapping incentive structure. For instance, if a relationship manager brings in a piece of business banking, relationship manager being primarily more consumer home lending oriented, not all of them but most of them, they bring in a piece of business banking which we do quite a lot of, the business banker and the relationship manager share a compensation but the totality of that is more than 100% from the bank’s point of view for either one. So we have a shared working arrangement that’s supported by an incentive program. It works very well actually. Whoever brings in the lead is the banker for life with the client unless the client changes. This is how we market, testimonials, this is quite short it will give you a quick example, “First Republic has certainly found the recipe for success. They always put the customer first.” “Everything is first rate with First Republic, the technology, service, fast turnaround.” “First Republic Trust Company is one of the best things that ever happened to me.” “We give the highest ratings to the quality in this bank.” “I like First Republic’s can do attitude. Their first answer is, ‘Let’s figure it out.’” “We got our mortgage through First Republic and the process was quick and painless.” “Everyone talks about putting the client first but few follow through. First Republic really does.” Those are just some examples, there is a particularly good example of someone who has a more complex financial life today than they did a short while ago. But we have a wide range group of clients but they are basically more or less self made. We have a lot of first generation banking, we don’t have a lot of second and third generation banking, that tends to stay where the trust accounts are, it’s hard to pull. We’re getting some of it now and we’re developing our own rather quickly because we’ve been at this more than a quarter century. The people we have as clients are the outperformers and so the growth of the enterprise comes from two places that are not immediately self evident but when you think about it are very intuitive. Our clients generally speaking, are the outperforms, so if the economic area in which they’re operating is growing at 2% their own personal balance sheet is growing at 4%, or 6%, or 8%, they outperform. So we have an intrinsic growth rate by the nature of our client. We also touch that client a lot of ways, those nine products, and as they grow they get more complicated so they don’t just grow vertically in terms of size of accounts and relationships, they grow horizontally in terms of complexity. We touch them a lot of places and a lot of different ways. That gives us a lot of opportunities to be right and they become quite passionate about the service they get from the bank because our competitive advantage is service. They become very passionate and they talk to like kind friends who they refer. 70% of our growth every year, it’s not about advertising, it’s not about new teams, it’s not about new offices, it’s about the core client base which has been established over a quarter of a century growing at a more rapid than normal rate and telling their friends because they’re having a successful, passionate service experience and they want to share it with their friends. 30%, more or less, comes from the more obvious things like hiring. If we stopped hiring tomorrow the bank would grow at 10% to 12%. No problem, in fact, it might grow faster because we’ve been distracted, we wouldn’t be distracted hiring new people. Opening new offices, we open three to four a year. This coming year we are going to open more because we have to build a pipeline coming out of BofA. Then, we have focused marketing. But the intrinsic growth rate of the enterprise is embedded in the clients that we deal with. It’s not predicated on getting the next hire right. Attractive markets, we operate in coastal urban markets. These markets have 20% of the households in America but they contain 53% of the high network households so they’re very target rich. High net worth being the Capgemini Study definition, households with $1 million or more in liquidity. Our penetration goes up each year, the Slide on the right hand side shows that we’re up to 4.3%. Let me show you how far this model can go in certain markets. Our home market is San Francisco, we have longevity and depth there. We have 16% of all such households bank with us. These numbers, by the way, are more than two years old we have a new study underway right now, we do it every two years. We have a 16% penetration in nine counties. In New York, which is the largest target certainly in America, maybe in the world, we had a 1.2% penetration so we have a long ways to go. We don’t need to go to new markets, we do not expect to go to new markets, possible exception of a deposit point on the east coast of Florida which we’re thinking about for northeast clients basically. There’s a lot to be done right here. Historical growth, you can run these charts back an extra 10 years and the percentages wouldn’t change much. Loans are strong, deposits are very strong, 20% plus growth rate for a long period of time through a range of markets. We’re strong in San Francisco, we’re particularly strong in Silicon Valley. That is helping us at this point obviously, but it has for a long time. We have about 35% of our loans in three counties

[Ericka Penala:]

Why don’t we start off the Q&A, you talked about business banking deposits Jim, and it sounded like you’re going deeper into your current relationships in order to obtain these business banking deposits, because of your momentum here would you ever change your approach in that you would lead with this product rather than leaving with the home loan product and then thereafter trying to get a piece of whatever business that home loan client is in?

[James H. Herbert:]

We actually do do that. We’re beginning to lead – we have business bankers, we have a whole dedicated group of business bankers and their job is to bring in their own business and to respond to referred business and I would say that’s about 20/80, 30/70. They bring in some, it varies of course by banker, and most of it is referred. Invariably, if we bring a client in business first, which is still the minority but still growing, we will end up almost invariably banking the principles. What happens is a business banker does the reverse, he or she brings in a relationship manager to start to do that. Then the other thing that happens is we’re doing some targeted loans to younger partners buying into firms and things of that nature, we call them partnership loans. That’s actually been going on for a while and is actually working out very well.

[Ericka Penala:]

Any questions from the room?

[Unidentified Analyst:]

First question is can you explain the big drop in the efficiency ratio in ’09? The other question was you guys had focused on debit cards for a while and I don’t know that you had a credit card, but with the drop in the debit card being [inaudible] are you guys rethinking that?

[James H. Herbert:]

We’re not rethinking it and we have no credit cards. We have some exchange fees coming out of ATM cards and we have a modest debit card business but it’s really very small so I think the impact of the new rules are going to be very nominal, as was the income quite frankly. The drop in the efficiency ratio in ’09, the [pink] of the efficiency ratio worst case was ’07, if I recall correctly and ’07 had in it one time cost of the transaction with Merrill so it’s a little misleading, but that’s the GAAP number. The historical number is that 71 that bridges sort of ’06 and ’08 and we dropped from there. You see, what happened was we grew, very rapidly inside Merrill and they constrained our hiring and our branch expansion and we actually learned a lot from that which was we could do this more efficiently than we thought we could. We actually took out of the Merrill and BofA experience a lot of interesting and positive things. It was a difficult time for everybody and the memories are fresh for everybody, but on the other hand we actually learned a lot and one of them was how to run a more efficient operation. We got that from BofA too.

[Unidentified Analyst:]

Were the lessons learned in terms of efficiency really to do with infrastructure versus the way your compensation model has always been set up?

[James H. Herbert:]

Yes, it’s more a matter of how far can you push certain things and has a lot to do with the discipline of if something small, whether it’s working or not, if it’s kind of distractionary get rid of it. We had sort of product start ups that we pulled back from why bother. We learned a lot about the efficiency in wealth management and putting everything together in one branch, having one platform. That’s a Merrill sort of takeaway that actually we’ve applied. It’s taken us a couple of years but we’re now there and I would say that we’ve managed to reduce the cost of the wealth management area by 20% on the same dollar of business. Then we didn’t hire. When you don’t get to hire it’s challenging so you look very carefully at the productivity of the people you have.

[Unidentified Analyst:]

In terms of how certain geographies are progressing could you give us an update on market share gains in the east coast specifically, New York City? Is the growth there beginning to outpace that of the west or is the momentum in Silicon Valley so solid that you’re not quite seeing that yet?

[James H. Herbert:]

It’s pretty hard to outrun Silicon Valley, it’s on a roll again. However, the numbers in the east are very, very strong, the base is not that large yet but it’s getting there. We have about a $5 billion institution maybe, between $5 and $6 billion at the bank level in the east. That’s a pretty good base now and it is growing percentage wise faster in the east than it is in the west but the base is smaller. The absolute growth of San Francisco in terms of the Silicon Valley influence is hard to beat. I don’t see it as a contest, I see them as both really good numbers, we’re in the mid teens to low 20s in each market. What’s happening is really simple a combination of three thing, the markets we’re in are holding up fairly well actually they’re coastal, urban, west side of LA, San Diego, San Francisco, Boston, New York primarily. There is a lot of activity beginning to happen. We are well funded and completely intact and operating with a very short decision change and can move quickly. We spend our life taking clients away from other banks, that’s what we do for a living. The clients we have are not standing on the corner looking for banks so we have to beat somebody and we’re pretty good at doing that. The competition, particularly the large competition is somewhat dislocated right now. Now, at almost any time somebody’s dislocated but right this moment, there is a general distraction going on for all the reasons we all know very well and so the opportunity is quite considerable. We’re also very lucky not to have faltered in the delivery that we’re able to deliver during the whole time we were not independent. In fact, in a way the best loan you’ve ever had is ’08 which is very counter intuitive but the reason is no one else was home and so we did a lot of business.

[Unidentified Analyst:]

I can do this offline, but I would actually like to know a little bit more about the way you guys accounted for the purchase back from Merrill and particularly on the bargain purchase accounting? Are you amortizing that up to the principle amount less expected loan charge offs or how that actually works and was there a positive impact on the amount of charge offs and the loss ratios on the purchase? Because, it looks like BofA essentially ate all the bad loans in that transaction. I read all your disclosure, I still couldn’t quite figure it out.

[James H. Herbert:]

Let me take it in the reverse order, when we bought back from BofA, the way the deal was negotiated we had the option of leaving behind up to $2.5 billion of assets of our choosing. We ended up leaving behind about $2.1 billion and in that $2.1 billion, if you had the choice, you would leave behind delinquent loans and various types of loans you didn’t any longer think were as good as they were when you made them. However, the delinquency in what we left behind, which was the entire delinquency of the bank, was not $400 million. Even then the delinquency was not 2% of the total portfolio at the time, that was our peak point almost. When we bought it, we bought it at a discount from face which the BofA had already marked it to in their acquisition of Merrill so we were, I suppose you could think of it as benefitted but it worked out that the loans were discounted as a result of the Merrill purchase and so there was an intrinsic discount on some of the assets anyway. We then applied mark-to-market purchase accounting which at the time ended up adding collectively another, if the discount coming in – I’m choosing numbers they’re in the offering, but about 4% we added probably another percent discount. Buried in that discount is a credit component to your question, and so what we did was we specifically identified certain loans which we identified needed specific reserve requirements and we put them against it so that’s in the credit component. That’s not being amortized except specifically loan-by-loan. As X loan pays off if it has a reserve it comes in, otherwise it doesn’t. The amortization of the discount amount, there were two types of core purchase accounting entries one was on the asset side and one was on the liabilities side. The asset side we marked the loans to – they were marked down from face. That’s the biggest number by far. The liabilities side, we marked our term CDs mostly and a few other draws, longer time liabilities rather, to the then market which provided a premium. On the asset side we’re doing a loan-by-loan specifically accounting bringing the discounts in. I don’t like pool stuff, that goes wrong on you, so we did loan-by-loan. On the liability side, we of course do specific liability. It’s quite mathematical. The piece you can’t call is when the loan discount will come in, that’s dependent on the life of the loan, but of course, with low rates it’s coming in faster than we thought it would.

[Unidentified Analyst:]

Two questions, one sort of contrast and compare your operation versus Northern Trust which would seem to be the most direct kind of competitor. The second is I guess a more off the wall kind of question, what happens if as some have predicted if there’s an earthquake in the San Francisco area?

[James H. Herbert:]

Well, Northern Trust is us plus 150 years. US Trust, Northern Trust, they’re a trust bank at this point, a very good one by the way. When we compete with them, which is seldom actually, because most of their business is the iceberg under the water which is they already have it in trust. The piece we see is up at the top poking up above the water looking for new clients. They are quasi bank like in that regard. They’re not big lenders of money. They do lend money but that’s not their core focus. So in the business of acquiring new clients we are doing a lot more of it than they do. But our standards for a new client, not in terms of quality, but in terms of quantity is much lower than theirs too. They’re looking for kind of minimums, we don’t go in that way at all. We’re lenders of money and we accumulate wealth assets as a result of having a client, they trust us and we grow with them and now they have some wealth management assets. Now, as our reputation has developed we actually are getting – we bank a number of family offices, we bank a number of billionaire family offices. But that’s a fairly recent event and most of them are first generation self made. An earthquake in San Francisco is a risk of the enterprise. I would say it’s probably the number one risk. An earthquake of an 8.0 variety in San Francisco has about statistically about a 1% chance each year of occurring. We’ve been through this though, we had the Loma Prieta and we had the North Ridge in LA and we were impacted a bit. The one in San Francisco actually did very little damage to the enterprise, we got through it quite well. It’s important to remember if you look back on that loan-to-value ratio on that home loan page, there’s two things about it, number one an earthquake is a very specific epicenter type thing and it matters a lot where that epicenter is. Then number two, if you look at the loan-to-value ratios on the home loans at 58% you’re not very far from land value in the Bay Area because the Bay Area land is very expensive. Most high end homes have about a 40/60 split land to structure make up and also our experience was we had amazingly enough zero home loan losses in either North Ridge or Loma Prieta. The reason is what I just said, the down payment, the economic capability of the borrower, and actually because they are by nature builders and fairly conservative, a lot of them have insurance although we can’t require it, it’s just not competitive, a lot of them have earthquake insurance, very few of them cashed on it. Having said that, if a very major earthquake hit in San Francisco central it would cause us a problem. We do insure our own premises, rather extensively, as you might imagine including business interruption insurance.

[Ericka Penala:]

Jim it’s pretty clear to me that there could be a potential benefit to balance sheet growth as conforming limits are now lower, but are there any wholesale changes to the US mortgage model that could be looming in Washington that you’re worried about as it could impact your operating model?

[James H. Herbert:]

Not specifically. I worry more about the generality of the focus of Washington to try and improve the mortgage market and to solve the home problem. I think we’d all agree it needs to be solved. Time, I would argue, is beginning to do that although it’s slow and it’s very painful for those involved in it. I think that if Washington decides to take policy action, all bets are off because you don’t know what they’re going to do. I think the other risk in all the tax decision, of course we’ve all heard that one of the things on the table is the deductibility of interest on a home mortgage, that would clearly have a negative impact on our business if it were completely eliminated. Although, I know Canada operates without deductibility and most countries do actually. But, I’ve been in the business since it was reduced down to what it is now and it had a modest impact but not that much. I also have a little trouble imaging them reducing it below agency level. That would be from the policy point of view, very inconsistent. But, you don’t know what is going on, the way it’s operating down there who knows. The other trend is this, one other pricing. I’ve been doing JUMBO home loans since 1980 at the bank I started before this one and everybody thought we were crazy for the first 25 years of those 30 years. Now, all of a sudden it’s the asset of choice because people are uncomfortable, and people being big banks, are uncomfortable with other assets so they’re coming at JUMBO home mortgages. So although the quality standards are still being held quite high, the pricing standards are beginning to tumble. Not just the interest rate levels we’re at, but even within those interest rate levels and so there’s some pressure on the asset class. I don’t worry about it very much because we’ve got eight other things so we have a matrix pricing and we can afford actually to be competitive. If we want a client, we will get them.

[Ericka Penala:]

I have to ask a question about the margin because it’s such a focus for bank investors today. You have been warehousing a lot of excess liquidity as deposit inflows have come in, now a lot of banks are getting pressure to deploy that cash into their bond portfolio. Is there conservatism partly because we don’t know what the duration or the stickiness of some of these new deposit inflows?

[James H. Herbert:]

It really is. Well, it’s two things we never rush credit and credit includes investing. We never rush credit we do good credit when we see it, we look for it, we try to find it, but if it isn’t there we don’t do something we don’t bend. Then number two, I’m not sure how sticky some of it is. In fact, I’m sure some of it isn’t. I think it’s kind of a fool’s gold to think the last billion dollars of deposits in checking in the unlimited checking account insurance account is a permanent deposit. I actually don’t believe it is. I believe we will keep proportionately a relatively good share of it because people become very comfortable with the balance sheet. One of the reasons we went public was to be transparent to our clients who know how to read a balance sheet, most of them do, and they care. We’re actually picking up clients from major institutions who are simply moving over. I don’t know if that’s permanent either actually, I think it is. So we figure that we have about $2.5 billion of liquidity at this point in cash at the Fed. Our normal run rate would be $500 to $500 million really.

[Ericka Penala:]

Maybe one last question for you, could you give us a sense in terms of timing or desire, because of your earnings power you continue to build capital even if you grow your balance sheet. In 2012 a successful exam could potentially open up distribution of capital, is that something that you’re open to or you’re continuing to warehouse the capital because you have such good growth ahead?

[James H. Herbert:]

Well I think it’s a balancing act. We think we have growth ahead, we certainly have had in the past but we also probably are slightly excessively capitalized for the growth we can foresee. Having said that, if it’s driven by deposits all bets are off. We’re open to dividends and we paid a dividend previously and we paid about a 20% payout ratio basically and we’d like to get there again I just don’t want to rush it with the regulators because we’re a de novo charter and we have to age that a little bit but we would get there eventually.

[Ericka Penala:]

I think if there are no other questions we’re about out of time. Thank you.

[James H. Herbert:]

Thank you all very much.