Shortly after First Republic’s troubles became public, I reviewed its investor presentation. One chart stood out to me: “Appendix: Business Activities Not Undertaken.” I’m a fan of this slide.
Twitter was quick to point out that Hingham Institution for Savings has a similar slide in its investor presentation entitled: “What We Don’t Do.” I reviewed Hingham’s deck and the page that precedes “What We Don’t Do” is entitled “What We Do.” (Even better these two slides are among the first slides in Hingham’s deck).
My own version looks like this
What Flynn Lending Partners Does
We make short-term private money loans to investors secured by deeds of trust
What Flynn Lending Partners Doesn’t Do
Medium to Long Term Lending
Commercial and Industrial Lending
Timberland/Farmland Lending
Consumer Real Estate Lending
Construction Lending
It’s hard to find fault with “First Republic’s Business Activities Not Undertaken” slide. While not everything on the list is a bad lending idea, it includes a who’s who of scary-sounding activities they avoid:
• No proprietary trading
• No market making in equities
• No trading assets or liabilities
• No cross-currency swaps
• No clearing services
• No banking or custody services to digital asset exchanges or service providers and no direct Bank investments in digital assets
• No underwriting transactions in debt and equity markets
• Not a commercial paper issuer, backstop provider or guarantor
• No underwriting of IPOs
• No exotic derivatives
• No junk bond investments (1)
• No foreign sovereign debt investments
• No wholesale lending or borrowing of securities to or from financial institutions
• No depository institution, foreign bank or credit union debt positions
• No loans to foreign governments
• No credit card issuance or auto loan originations
• No low-doc or no-doc subprime lending
• No negative amortization loans (minimal amount in runoff)
It also contains a list of various non-ESG-related activities that they refuse to participate in.
First Republic’s problems have been well documented and of course I don’t know whether or not it survives as a standalone financial institution. I just want to underscore two points:
You can lend to the best borrowers at great LTVs but you have to get paid an appropriate risk premium to assume interest rate risk.
It’s better to be feared than loved, but if you’re loved, be sure it’s only for the “right” reasons.
You Need to Be Paid…
To my first point, regardless of your borrower’s strength, be it an ultra high net worth individual, a state or even the federal government, you’ve got to get paid for lending. Earning negative real yields on long-term paper is crazy.
First Republic avoided credit risk but assumed outsized interest rate risk at negative real rates. This defied common sense. Check out this article I wrote in 2020 advocating the inverse, borrow long at fixed rates and lend short.
Like most private money lenders, our loans involve credit risk but their short terms means we assume very little interest rate and very little market risk related to the value of the loan collateral. Might things have been different had First Republic accepted more credit risk and less interest rate risk in its portfolio?
To Be Loved…
To my second point, why do your clients like or love you? I want feedback from my borrowers. But all feedback isn’t created equal. If a borrower says, “Bob you need an easier loan process”—that’s one thing. If a borrower keeps returning for loans but wants a higher LTV or cheaper rate, that’s another thing. I take the first suggestion to heart and ignore the second suggestion and just focus on my borrower’s demonstrated behavior. I want to be loved for being easy to work with, for performing, for closing fast—but not for offering the best rate and terms.
By all accounts First Republic’s clients love the bank. They love it for the fresh cookies, the hands-on client service, and the ease of doing business with First Republic. But do they also love it because of the low-interest rate loans and favorable loan terms?
In June of 2022, someone close to me refinanced his primary residence with First Republic with a 10-year, interest-only loan at a 75% LTV and a rate of 3.9%. As a reminder, by Q2 of 2022, everyone in real estate and banking was aware that rates were sharply rising. The Fed had made its intentions clear. Check out this tweet I sent in April 2022 related to rising rates:
In retrospect, given the culture of client service and the expense load (~60% efficiency ratio) that accompanies that, optimizing for First Republic’s survival would have meant shrinking its balance sheet. It would have meant raising deposit rates slower and letting deposits walk out the door, holding shorter term municipal bonds or short term treasuries in lieu of long term MBS. Maybe optimizing for First Republic’s survival would have even meant being loved for everything except for the rates and terms it offered its borrowers.