First Republic Bank
First Republic Bank (FRC, Financial) is one of the most differentiated business models in our large cap universe. What makes the Company so different is not necessarily the activities that it does, but the activities it does not do. These trade-offs are an incredibly important strategic decision that every company must make. However, in our experience, rarely are these forgone activities lauded or even recognized as critical differentiators. The Company does mention these foregone activities, on page 45 of its most recent investor presentation appendix: https://ir.firstrepublic.com/static-files/ece71088-a3ee-41de-b58c-5f2bffc4bc2c.
When we consider the financial industry, especially banking, is fraught with competition, simply being better than any of the other massive money-center banks is not enough to sustain many decades or even years of superior performance. Rather than try to outcompete every bank in the country, First Republic’s competitive strategy of doing only a handful of things well, results in a superior value proposition to its customers. These trade-offs are easy to understand, but difficult to copy, given widespread competitive and institutional imperatives that pressure management teams to revert to the mean.
First Republic organizes its entire business around keeping long-term relationships with its bankers and clients. This strategic decision contrasts with competitors that have underlying strategic goals to drive as much client activity as possible. As a result, client development activities at First Republic look very different from those of its competitors. For example, while most companies strive – or at least market – to provide excellent client service by bombarding clients with digital touchpoints, First Republic will not open an account with its typical well-healed client without first engaging in a personal conversation. For many, this sounds like an arduous and inefficient task that can be handled or even automated by scores of digital software solutions. Paradoxically, First Republic has outgrown its peers over the past several years. The Company compounded revenues at an +18% rate from 2016 to 2021 and is now one of largest single family mortgage lenders in the U.S.
Despite this impressive top-line growth, particularly in first mortgages, First Republic doesn’t even make the top-10 list of annual mortgage volume generators. In contrast to the vast majority in the banking industry that sells its mortgages to government-sponsored enterprises (GSE), First Republic keeps nearly all its mortgage underwriting loans on its balance sheet. Part of this is because of necessity – First Republic underwrites mostly non-conforming or “jumbo” mortgages that are ineligible to be purchased by GSEs. But the strategic decision to avoid the correspondent mortgage industry aligns the Company with its customers and shareholders because a long-term servicer and underwriter relationship favors more prudent underwriting standards and more favorable long-term economics. This is borne out in the Company’s industry-low, net charge off ratios over the past few business cycles.
And more recently, the dramatic rise in long-term interest rates has caused mortgage industry underwriting volumes to plummet – mostly due to a decline in refinance activity. Despite this, and admittedly to our surprise, First Republic turned in an astonishing +23% growth rate in mortgage originations during the second quarter of 2022. That is not to say things won’t slow from here, given the continued rise in rates, but it was another important, contrasting data point of how the Company’s business model differs from most large money-center peers. Competitors’ overwhelming reliance on the securitization markets as well as mortgage correspondent mass-market focus was in no small part to blame for the industry slowdown. As First Republic keeps these functions in-house and focuses mostly on jumbo mortgage financing, there were no third parties or vendor partner upheavals that the Company had to contend with to continue providing its customers with reliable mortgage underwriting service.
Of course, to execute this client-centric approach of providing superior customer service, the Company’s entire capital structure must align to this goal. For example, banks are required to hold a larger buffer of capital for on-balance sheet mortgages than, for example, a mortgage-backed security. As a result, First Republic has less capacity to repurchase shares by holding on to mortgages. But again, paradoxically, First Republic equity has traded at premium earnings multiple relative to banking peers for the past several years, despite rivals that have been repurchasing tens of billions in shares. In addition, and unlike nearly all large cap banks in the U.S., First Republic does not offer any kind of credit card product to its personal banking customers. We think the advantages of this trade-off are multifold. First, credit cards are a low-touch business, where most of the interactions are between the customer and a merchant, so First Republic has very little ability to influence the customer experience in that framework. Second, credit card receivables take up a disproportionate amount of balance sheet capacity compared to other forms of lending, albeit at higher interest rates. The Company has chosen to preserve this capacity primarily for mortgage lending as we view mortgage lending provides a better opportunity for stable, long-term customer relationships rather than revolving consumer credit. Last, regardless of consumer credit quality, credit cards tend to have higher charge-off rates than other forms of secured lending, which helps the Company avoid spikes in charge-offs during inevitable recessions.
In conclusion, while being the most profitable or fastest growing business are certainly the goals most businesses strive for, we are steadfast in our view those goals must be by-products of a differentiated competitive strategy. In the highly competitive industry of personal banking, First Republic has made a concerted effort to focus on only a handful of activities to excel at while actively avoiding many others, even when those activities might seem to be industry-standard offerings. First Republics’ prudent and deliberate approach to trade-offs offers competitive differentiation that should continue to drive exceptional growth over the long term.
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners second-quarter 2022 letter.
