Facing margin compression
First Republic is largely in the business of serving high-net-worth individuals in the coastal regions -- think San Francisco, Los Angeles, New York City, Boston, and other similar markets.
Image source: Getty Images.
It does this by providing a high-touch customer service model that its customers love, leading them to come back to the bank for return business and refer their friends to the bank, which leads to lower customer acquisition costs.
First Republic has established a pretty strong deposit base, and while it has a good lending franchise as well, it largely originates jumbo mortgages and multifamily loans, which are lower-interest rate products. Additionally, at the end of September, about 36% of First Republic's loans were fixed rate, meaning their associated yields will not reprice higher with the Federal Reserve's overnight benchmark lending rate, the federal funds rate.
As the Fed executes its quantitative tightening program, effectively pulling liquidity out of the economy, not only are customers seeking more yield on their deposits, but they are also seeing deposits leave the banking system.
This has led to higher deposit costs outpacing higher loan yields at First Republic, pressuring its net interest margin (NIM), which is essentially the difference between the money that banks make on interest-earning assets such as loans and pay out on interest-bearing liabilities such as deposits. First Republic saw its NIM fall 23 basis points (1 basis point = 0.01%) to 2.45% in the fourth quarter of the year.
Management is also guiding for NIM to fall another 25 to 30 basis points this year, and that's assuming the Fed does a rate cut this year, so things are going to get worse before they get better.
Making gains
Despite the fact that higher interest rates have started to cut into loan growth at most banks, First Republic has been very successful within its specific lending niches. Mortgage loan balances at the bank jumped about 29% in 2022, multifamily loan balances grew 35%, and commercial real estate loans grew 27%.
Rising interest rates have really depressed mortgage volume, particularly on the refinancing side, but it's also started to bring down home values, which is presenting investment and buying opportunities that high-net-worth individuals have more flexibility to move on than your traditional homebuyer. First Republic is guiding for strong loan growth in the mid-teen percentage range for 2023.
NYSE: FRC
Key Data Points
Now, some of this loan growth is likely to actually hurt the bank's NIM and earnings because First Republic will have to bring higher-cost deposits on the balance sheet to fund this growth. But management believes the short-term earnings hit will be worth it long-term.
"Well, this [is a] disruptive moment, and we all know that the mortgage market is being disrupted a little bit is an extraordinary opportunity for us to take share. The moments like this are very special," First Republic's Chief Banking Officer Mike Selfridge said on the company's earnings call. "It's on a silver platter."
A phenomenal track record
If this had been a different bank with less of a track record, I would probably understand more skepticism from analysts and investors.
But First Republic has really been an exemplary bank stock. Every bank says they are good at customer service, but First Republic has the data and results to prove it. Since Executive Chairman Jim Herbert purchased and took the bank public in 2010, the stock has gone up more than 418%.
The bank has had superb credit quality since it was founded and knows how to turn a customer into an extremely profitable lifetime member. Investors should be more than happy to sacrifice earnings in 2023 in order to gain market share that will pay off down the line.
