Bailouts really stink. They wipe out shareholders, they leave taxpayers responsible for millions or even billions of dollars, and, perhaps worst of all, they let poor management teams off the hook for years of bad decision-making.
Based on my research, though, there's one bank that will never need a bailout. This bank is different.
I'm talking about First Republic Bank (FRC +0.00%), whose strength lies in the loans it makes to particular clientele.
Source: First Republic Bank.
Why credit quality matters more than anything else
The core business of banking is accepting deposits and leveraging those deposits by turning them into loans. The bank pays a little interest to depositors, earns a bit more on loans, and keeps the difference as profit. Pretty simple stuff.
For long-term bank investors, though, that process isn't quite as simple as it sounds. As of Sept. 30, the FDIC reported that over 6,589 banks operate in the United States. That's a ton of competition. To compete, banks oftentimes make loans that are not of the highest quality. Low-quality loans often don't get repaid, and when that happens, banks fail. And when banks fail, bailouts follow.
It seems almost too obvious, but the banks that perform the best over the long term are the banks that make the best loans, which get repaid in the good times and in the bad. The best loans are made to borrowers with plenty of cash flow, high credit scores, lots of cash in the bank, and a personal financial statement loaded with high-quality assets that could be sold and used to pay off the debt in the worst-case scenario.
In other words, the best loans are loans to the wealthy. And that's precisely First Republic Bank's specialty.
The secret sauce
First Republic Bank is a regional bank, but not in the traditional sense. The bank has 71 offices located exclusively in seven cities on the U.S. east and west coasts. The bank's primary product is mortgage loans to wealthy individuals, but it also offers complementary products designed specifically to serve these wealthy families, such as business loans, wealth management services, treasury and cash management, and consumer loans -- all the products that a typical wealthy family would need to manage its financial life.
First Republic does not get involved in subprime lending, mortgages with high loan-to-value ratios, or payday loans. These products are all risky, but more importantly, First Republic's wealthy client base has no need for them. It's a win-win-win for clients, the bank, and investors. For a more detailed breakdown of First Republic's exact income streams, click here.
Impressive underwriting standards lead to impressive results
It's rare for a bank to talk publicly about its underwriting standards for making a loan. First Republic is one of the few that put that information front and center in its investor-relations material. The reason is that the metrics are ridiculously strong.
The bank's customers have a median credit score of 774, median net worth of $2.5 million, and median liquid assets of $583,000. The bank's weighted average loan-to-value ratio for mortgage loans is 61%. The typical down payment is 39% -- far more than the 20% or less that's typical at other banks.
The bank's credit quality metrics are, unsurprisingly, incredible. For the fourth quarter of 2014, the bank reported that just 0.10% of its assets were non-performing. Non-performing assets include loans that are 90 days or more past due and foreclosed properties. The bank charged off (i.e., took a loss on) a scant 0.01% of its loans for the year.
For context, the most recent FDIC Quarterly Banking Profile reports that the average bank with total assets of more than $10 billion charged off 0.53% of its loan portfolio as a loss -- 53 times more than First Republic.
Think this quarter is a fluke? Think again. The following chart shows the bank's net charge-off ratio over the past 10 years on a quarter-over-quarter basis.
Source: BankRegData.com.
That's right: The bank's worst quarter in this chart showed charge-offs of just 0.16%. The industry average for that quarter was 0.68%.
The bottom line is that First Republic makes good loans that get repaid. This is the secret sauce.
This bank is special
Other banks aren't built to produce this level of credit quality. Community banks seek to serve their community -- both the elite wealthy and the middle- and lower-income constituents. Megabanks attempt to serve everyone, from the largest corporations to the lowest-income, under-banked communities. Inherently, that broader strategy will lower the standards for getting a loan.
First Republic has a different stated mission. Its entire bank is designed to serve the needs of the rich. The business model is unique. It's hard to execute, but it works.
If you're looking for a bank stock that will never need a bailout, has a low risk profile, and can weather an economic recession, look no further. First Republic Bank may be the stock for you.
