First Republic Bank

Welcome to First Republic Bank’s third quarter 2014 conference call. Speaking today will be Jim Herbert, the Bank’s Chairman and Chief Executive Officer; Katherine August-deWilde, President; Mike Selfridge, Chief Operating Officer; and Mike Roffler, Deputy Chief Financial Officer.

Before I hand the call over to Jim, please note that we may make forward-looking statements during today’s call that are subject to risks, uncertainties, and assumptions. In addition, some of our discussion may include non-GAAP financial measures.

For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements and reconciliations of non-GAAP financial measures see the Bank’s FDIC filings including the Form 8K filed today, all available on the Bank’s website. Now, I would like to turn the call over to Jim Herbert.

We had a very good quarter. We successfully balanced a number of key objectives.

Core revenues were up 21% year-over-year. Our loan volume was excellent.

This is our third best quarter ever. Checking is now 55% of total deposits.

We very effectively managed the growth of the balance sheet and quite importantly, we sold $1.8 billion in loans during the quarter, the most ever. We do continue to expect loan growth for the full year to be between 11% and 13%.

Credit quality remains very strong and our wealth management revenues were up 5.3% quarter-over-quarter and fully 32% year-over-year. We also repositioned part of our securities portfolio to further enhance our own balance sheet liquidity by increasing our holdings of high quality liquid assets.

Our expenses came in as expected. Let me speak for a moment about our continuation preparation to grow past $50 billion in total banking assets.

We’re making very good progress in the infrastructure to operate in this enhanced regulatory environment. All of our initiatives are well under way and appear to be under good control.

A meaningful portion of the expenses that are and will be associated with this regulatory buildup are expected to be somewhat offset by our cost containment efforts. Looking forward to the fourth quarter we expect good loan volume but obviously, some pressure on net interest margins.

Overall, we’re very pleased with the way we were able to execute on a number of different objectives during the past quarter. Most importantly of all, our very intensely client focused business model continues to operate uninterrupted.

We had very strong loan origination and client acquisition climbed during the quarter. Let me turn the call over to Katherine now.

I’d like to cover some of the key numbers for the quarter and then talk about loan origination volume, loan sales, deposit growth and wealth management. Core earnings per share were $0.81 or $0.71 after the one-time $0.10 per share gain from securities sales.

It was our second best quarter ever. Loan volume was $4.7 billion which was our third best quarter ever.

Our pipeline remains strong. Although we were down a bit compared to the last quarter, our pipeline is up significantly over this time last year.

Credit quality remains very strong. Non-performing assets are only 11 basis points of total assets.

Purchase activity remains robust in our markets. During the quarter home purchases accounted for 61% of single family loan originations.

The weighted average loan-to-value on all of our new single family loans was 60% for the quarter. Increasing demand for our high quality mortgages resulted in record loan sales during the quarter.

We sold $1.8 billion of home loans and realized a gain of $13.7 million. Year-to-date we’ve sold $3.4 billion of home loans to nine different buyers with gains of $31.4 million.

These multiple buyers and their third-party due diligence teams rigorously examined the loan packages providing independent confirmation of our underwriting standards, loan documentation, and credit quality. Continued strong demand for our loans also provides considerable liquidity as this quarter certainly showed.

We have an ongoing focus on managing both the asset and liability sides of our balance sheet. This is demonstrated by our loan sales activity.

In addition, we managed deposit funding to be appropriate for our asset growth. Deposits increased 1.6% for the quarter and 15% annualized for the year.

We are very pleased with our deposit mix. Checking is 55% of total deposits.

The average contractual rate on deposits was 19 basis points in the quarter. Private wealth management had another very strong quarter.

Well management revenues were up 32% compared to the same quarter a year ago. Assets under management increased 34% year-over-year.

This increase was predominately due to net client inflows. Overall, we are very pleased with the quarter.

Now, I’d like to turn the call over to Mike Selfridge.

I’d like to talk about business banking and the conditions in our markets, but first I’d like to cover a few key metrics for the quarter. First Republic continues to be very well capitalized.

Our tier-1 leverage ratio remains strong at approximately 9.5%. Our tier-1 common equity ratio also remains strong at approximately 11%.

Book value per common share was $27.48, up almost 14% from last year. All of First Republic’s urban coastal markets are performing very well.

This is especially true of the San Francisco Bay Area, our largest market, which represents 46% of the Bank’s loan portfolio. A few statistics about the San Francisco region are worth noting.

The Bay Area has the highest GDP per capita in the United States. More Fortune 500 countries are located in the Bay Area than any other US region with the exception of New York which is First Republic’s second largest market.

The Bay Area has the largest number of top 10 ranked graduate programs in business, law, medicine, and engineering in the nation as well as the highest concentration of venture capital in the world. The vibrancy of the San Francisco Bay Area economy is a key driver of both our private banking and private business banking.

With regard to business banking, First Republic had another excellent quarter. Business loans outstanding grew nicely in the third quarter.

Our business banking activity continues to be an important driver for deposit gathering with $4 of business banking deposits for each $1 of loans outstanding. The success of business banking also demonstrates how our service focused business model drivers franchise development.

Our satisfied private banking clients continue to introduce First Republic to the businesses and non-profits they manage or influence. Overall, it was a very good quarter and now I’d like to turn the call over to Mike Roffler.

I would like to discuss our core revenues, net interest margin, the securities portfolio, expenses, and our efficiency ratio briefly. As Jim indicated, core revenues were up 2.5% quarter-over-quarter and 21% year-over-year.

The modest decline of seven basis points in our net interest margin was approximately half from the contractual loan yield and half from higher average cash balances and the full quarterly cost of our unsecured fixed rate senior notes issued in June. Importantly, core net interest income was up 2.6% quarter-over-quarter and 15% year-over-year.

As disclosed in our recently issued 8K, at the end of the quarter we took meaningful steps to restructure our investment portfolio. This restructuring included the sale of $1.3 billion of securities which resulted in a gain of approximately $23 million or $0.10 per share after tax.

We reinvested proceeds from these sales into securities that are considered high quality liquid assets from a regulatory perspective. This further enhances our on balance sheet liquidity.

The portfolio of such investments totaled $2.2 billion at September 30th. We plan to continue systematically enhancing on balance liquidity in future quarters.

Turning to non-interest expense which was $238 million for the quarter, in line with our expectations. Excluding the gains on investment securities, the core efficiency ratio was 58.7% for the quarter, well within our previously disclosed range.

As Jim mentioned, we have recently initiated cost containment efforts which will start to have a positive impact in the fourth quarter. These cost containment efforts were focused on a reduction in non-regulatory headcount, decreased marketing and advertising expenditures, and certain vendor renegotiations.

Importantly, key to the execution of this effort is maintaining a balanced investment in future franchise development and an uninterrupted focus on regulatory related items. Accordingly, we continue to expect, through the end of 2015, a core efficiency ratio of 57% to 61% excluding the normal seasonal impact of elevated payroll taxes in the first quarter.

Now I’d like to turn the call back to Jim.

Overall, we’re quite pleased with the third quarter. We made tremendous progress in the quarter in preparation for an enhanced regulatory environment as we grow past $50 billion.

We’ll continue to work very hard on executing these numerous enhancements. While achieving all of this the franchise has continued to perform very well across the board.

We had strong loan volume, record loan sales, strong wealth management growth, very strong continued credit quality, and strong capital. Importantly, core earnings per share were our second best ever.

Now, we’d like to turn the call over for questions please.

Jim, I wanted to start first on the expenses which increased $16 million quarter-over-quarter so it was right in line with the $15 million to $20 million range you provided. Now, in one of the mid quarter updates you talked about a $10 million per quarter average going forward.

Now, how do we think about this in the context of the fourth quarter relative to where we stand now? Do expenses go down by $6 million to that range?

Do they increase by $10 million and stay at that level? I’m hoping you can help us calibrate to the fourth quarter?

I’m going to ask Mike to help me on the numbers here but the run rate guidance we had provided in the $10 million to $15 million range regulatory driven increase will continue. What is beginning in the fourth quarter is some offset coming from our cost containment activities.

If you look at the total expense, which was about $238 million, I think the fourth quarter will trend up just slightly because we’re starting to see benefit from the cost containment program.

Mike, maybe a follow up on that, can you give us a range of what the potential cost savings might look like from what you’re doing?

We think it’s probably – I think in our mid quarter update we provided this $10 million per quarter on the regulatory front and we think the cost containment efforts will be meaningful and so we think of it as sort of about half.

Then to shift gears maybe for a minute on the loan originations came in much stronger than I was looking for. Can you give some color on what really drove that growth in the third quarter and given the downward pressure we’re seeing on the yield curve, are rates low enough now where you could see a refi wave pick up again?

The purchase activity was very heavy in the third quarter and because of our relationships with realtors and our historic good job that we do, particularly in the purchase market, our business was very strong and of course, as you know, our markets are doing very well. Yes, the downtick in rates the last week or so has actually caused some refi activity to pick up.

Finally, expectations for loan sales here in the fourth quarter, should we think about a similar level and maybe a similar level of gain on loan sales?

Probably not a similar level Steve because we were intensely managing the balance sheet growth in the quarter, plus we had tremendous demand.

So maybe an improvement again on loan sales?

Maybe, but definitely lower sale volume.

My first question is just on the timing of balance sheet repositioning. I was wondering when in the quarter the $1.6 billion HQLA was positioned onto your balance sheet and sort of the $1.3 billion in securities sold were yielding versus what the yields are on the $1.6 billion in HQLA?

The repositioning happened pretty late in the quarter, the later part of September. The securities that we sold were the CLOs and CMBS, they had a blended yield of about 2.6% and the repositioning yield that will go into HQLA will be similar to that yield on the portfolio we sold.

In terms of the timing of LCR compliance, does the timing of compliance really start when you cross the $50 billion threshold and so the initial phase in doesn’t apply to the bank?

Erika, the LCR rules are out and final and we’re not a bank holding company so the technical aspects of them may not entirely apply to us. We would expect to be however, operationally LCRA compliant conceptually and strategically by the end of ’15.

Just one more, Jim, we’re starting to hear conjecture regarding potentially raising the asset bar in terms of above $50 billion in assets and a lot of investors are wondering whether or not if they do raise the bar in terms of the extra scrutiny if that would have any impact on the run rate of your expenses, or is it simply that you’re positioning this bank to be much bigger than right above $50 billion?

It’s really more the later. We’re basically focused on the regulatory enhancements that are appropriate for a larger bank and we intend to achieve them and it would be nice if they raised the limit but I doubt if it would impact us very much because we intend to run a bank that is going to grow well past $50 billion anyway and so we think the standards are appropriate and we’re bringing our bar up to meet them.

Just a question on the efficiency ratio range you provided the 57 to 61, why is there such a wide range around that? Is it possible that expenses do end up having that much variability or what are you foreseeing that might come up as an unforeseen item?

I think one of the things obviously you even saw impact this quarter, gain on sale revenues tend to be up and down a bit. This quarter it would have helped decrease the ratio a bit and if we’ve reduced the volume, like we talked about earlier, and if the margins are where they were you’re going to have less revenues there so it’s sort of both the revenue and expense side is why the range could tick up a little bit.

Also, I would add that we’re in a change moment for the enterprise so whenever you get into – I won’t say uncharted territory but new territory you can’t be quite as sure of the range and so we’ve widened it out to allow ourselves flexibility. That flexibility will mostly be needed relative to timing rather than a long term run rate.

Then the second question I had just in terms of the HQLA, I think I heard you guys say the yield was about the same as what you sold, but given 10 year treasuries at 2.1% right now, what exactly are you buying or what did you buy on the HQLA side that would yield such a decent return?

I think we look at the types of things that qualify the HQLA, federal agencies, and I think importantly the overall securities yield which includes the municipal portfolio was around 5% for the quarter and we think that that holds as we go into the fourth quarter.

You’re saying you’re investing in HQLA which includes munis?

No.

I guess I was asking what is the HQLA that you actually bought that has a similar 2.6% yield?

We’ll disclose that in the 10Q but the overall yield on the portfolio in the fourth quarter on our entire investment portfolio will be approximately the same as the third quarter.

Just a question on the HQLA, I was just curious, I think we’re at what $2.1 billion or $2.2 billion today, I’m just curious how much more build is left to be compliant by 2015?

It’s hard to determine exactly because we’re still working on the liabilities side of the analysis. But, we’re well on our way but we have a considerable addition yet to be had over the next 12 months, so 15 months.

Just curious, you mentioned the yield on the HQLA this quarter was actually in line with what you sold, I guess that seems a little bit high. How far out the curve are you guys reaching?

Is there increased duration risk to kind of offset that?

There’s some increased duration risk but not very far out, a couple years. I’d point out that we just sold $1.8 billion of loans that had a duration of about five years.

We have plenty of room for duration risk.

Then just last question, in terms of obviously gain on sale pricing quarter-to-quarter is going to swing around every quarter, at 67 bips this quarter, is there a level where it just doesn’t make sense to sell and you guys would portfolio it rather than manage the balance sheet or would you take whatever price the market is giving at the time?

I think you have to look at the average which is about where we were this quarter. Actually, this quarter was a little bit below our eight quarter average and we look to sell loans and have a lot of bids on loans both to manage our asset liability management and also to manage our growth rate.

There are certainly prices at which we would definitely not sell loans. I don’t expect that to happen right now.

Mike, you noted that expenses should tick up a little bit in the fourth quarter given you’ll start to get some of the cost savings into the run rate. But I guess looking beyond the fourth quarter, you likely already have a lot of the regulatory cost in the run rate, so would the cost savings that you highlighted be enough to offset the core inflation of the franchise or do you think we should expect to continue to see an upward bias on expenses into 2015?

I think probably a little bit of upward bias but I do think the cost containment helps to reduce that normal investment in the franchise that we’re always balancing looking at opportunities in the market. But the cost containment will definitely help reduce what you might have seen before.

Just a follow up to one of the earlier questions, just given how low rates are today, we’ve heard others talking about decisions to reinvest and I was just wondering, is there any thought process to just pushing out the time to build the securities portfolio so maybe it doesn’t happen over the next one to two quarters but you delay it until later in 2015 where rates in theory, could be higher?

We have some flexibility on our timing as you’re implying Ryan, and we would expect to use that.

Sorry to beat a dead horse here on the HQLA, but you mentioned you needed to add a considerable portion to that position. I was just trying to get a sense of magnitude without trying to nail you down to a specific number.

At this point are you thinking you need to double that $2.2 billion or do you think you’ll need to add less than that?

No, I think a double is in the right range.

Then as we look at the cash position, I know that excess cash was up a little bit. How are you thinking about that liquidity in this environment?

Is this $1 billion to $1.5 billion range a good range to expect going forward?

I would say that’s probably a little higher than we might normally have but it’s sort of in the right range. I would say close to $1 billion to above $1 billion is kind of the operating range.

The loan sales delivered mostly right at the end of the quarter, that’s part of the source of the cash.

Just one last one, I guess give the HQLA securities that you’re buying, how much of those yields come down over the last few weeks?

Probably between 25 and 50 basis points, something of that order.

I guess just a question on the margin, just given all the balance sheet repositioning you’ve done just curious what the core margin at 309 this quarter, what kind of starting point or range might we be looking at for the fourth quarter given the actions you’re taking and contemplating?

I think the loan yields, obviously with what is happening right now you could see a slight tick down because the new business is a little bit less than the portfolio yield. But I think our deposit costs are relatively consistent and the securities yield, as we’ve talked, should be in line with where it was over all this quarter.

So that probably ticks to a slight tick down in the fourth quarter based on what’s happening right now.

Then I guess I was also curious in general, what’s been happening in your markets and how is the market the last couple of month in terms of inventory levels and what sort of impact do you see this recent stock market meltdown kind of having on the housing market, if any?

We realize there’s a lot of talk about inventory issues. What we’re finding is that our clients seem to be winning the purchases, perhaps with our help and our commitment letters.

So there is enough inventory for the clients that we’re working with to buy houses and that’s terrific. Generally, when there is a decline in the stock market there is a pause in purchase activity but when there’s a decline in purchase activity because of the stock market variations like this and rates are down, we see an uptick in refi activity and we usually get more than our share.

I think if I could add to that it’s worth noting that our backlog at this point is up fairly meaningfully year-over-year. So, although we’re down slightly from the third quarter, which was very strong obviously, we’re so far, the loan volume is fine.

Just two questions, one I wanted to reconfirm that you’re still managing on balance sheet loan growth of 11% to 13% this year?

Yes, we are.

Any thoughts about going into 2015 on the same number?

We really haven’t projected forward.

The second question is around the regulatory cost. Now that you’ve had two quarters or so to dig into what’s needed for the investment spending, could you sort of break out what’s needed for the investment spending?

Could you breakout the increase in regulatory costs, where the spend is actually going, in which specific areas you’ve been building?

I’d point you to two places on our P&L probably. One would be professional fees, as we talked about there is some costs of engaging consultants in the early stages of several of these work efforts and then there is some increase in comp as we’ve added people for the different areas that are also impacted.

Any color in terms of how many people you’re actually adding on from the sort of regulatory perspective?

We haven’t provided that yet. We might speak to that in the 10Q but I’d rather not respond to it right now Lana.

Just back to the mortgage stuff, just to reiterate something, and sorry if you’ve already commented on this, but again around the volume you expect to sell in your mortgage production, you do expect that to come off a bit from the $1.8 I believe you indicated. Can you give us an idea should it still remain above the second quarter level?

I think it’s worth looking at our average quarterly loan sales. We would expect it to come off quite a bit from this quarter which was our highest ever and be more in line with our average quarters which have been about 850.

Then in terms of the gain on sale, just to confirm that again, you also expect that that could pull back a little bit from the 67 bips?

Actually, I didn’t say that. I said it’s worth looking at the average gain on sale and we put out packages and we’re never quite sure what the demand will be but we usually get a number of bidders on each package and quarter-to-quarter it has varied a bit but overall, it’s been about 70 basis points.

Can you just confirm what are you selling and what are you putting on balance sheet here in terms of by products in the resi portfolio?

What we are putting on balance sheet and what we are selling is about the same thing. There’s great demand for five and seven year fixed rate loans.

There is also demand with 30 year loans which we sell generally on a slow basis and we don’t sell our purely monthly adjustables.

Lastly, I just wanted to get a feel on the 2015 expense outlook you had indicated that there is going to be that slight upwards bias. I just wanted to see if you could help us at all in thinking about the magnitude of the increase you could see off of the second half level here in the 240 range total expenses?

I guess I would continue to try to point us to our efficiency ratio guidance instead of a pure number for the year and that we should be in that 57 to 61 range.

Most of my questions have been answered, maybe one with respect to the pipeline. Katherine, you gave some color on where that stands relative to the prior quarters.

I’m wondering if you could break it down a little bit more in terms of how much of the pipeline is residential mortgage versus other loans?

It’s about the same percentages as it has always been. That hasn’t changed very much.

I would just tell you that we’re up considerably from a year ago and we’re up in all categories. [Inaudible] the majority of our originations, about 50% tend to be in the home loan area.

Over the past year you guys have continued to put on continued strong deposit growth as well. If I recall you guys had a fair bit of deposit concentration, I’m wondering if you could remind me kind of what percentage of deposits come from your largest depositors and what types of customers those are and how that’s changed as you’ve continued to grow your deposit base?

I would take you back to June 30 which is in our Q and it’s been around 40%.

We’ll update it.

Can you provide more color in terms of what that 40% represents?

It’s a mix of clients geographically dispersed, not inner related, a couple thousand clients spread across the bank where we have very deep relationships with.

I guess the last question I have is as we look at the HQLA incremental growth here, would we expect to see more repositioning within the securities portfolio selling other securities to move into the HQLA or would that be net new growth to the securities portfolio?

It will probably be mostly net new growth.

I guess, what’s change from when we last heard it was looking at more like $300 million per quarter on the HQLA build to now really more doubling that to get to that target sort of by the end of 2015?

The growth rate is probably in the right range still but we decided to take a more bold approach to it and establish an initial position that we feel is very strong relative to the current balance sheet.

I have a couple of follow up questions. One, on your wealth management assets could you give us a breakdown between what came in from new clients or new assets on your clients versus market appreciation?

A large majority of the assets were from net new client inflow. It was a very choppy quarter in terms of market.

Then on your CRE and C&I originations they were up nicely linked quarter especially on C&I, so could you talk a little bit about some of the trends behind that and what we should think in terms of the outlook for the next several quarters in terms of the C&I growth, are you opening new verticals or is it just simply you captured a few new clients? How should we think about sustainability of said growth?

I think it’s the latter, we have not opened any new verticals. We had good growth, predominately private equity venture capital as well as schools and non-profits.

Your growth rate in CRE and C&I is kind of on trend and sustainable?

That’s about right, correct.

Finally, on the cost containment you were talking about having an effect starting next quarter is that $5 million roughly that you were kind of talking about going to hit all in next quarter or is it going to get phased in over the course of next several quarters?

I would say it’s going to get phased in so it will be a little less in the fourth quarter and start to be more fully phased in in 2015.

Finally, on the gain on sale margin, the 67 basis points and the 70 basis point kind of long term average [inaudible], how much of your gain on sale margin fluctuates with the volume of loans that you’re selling to the market versus how much of that fluctuates with rates changing so with what we’ve seen in the rates recently would that have a direct negative impact on your margin given the kind of loans you sell are not the 30 years for the most part so their underlying rates don’t move as much?

It doesn’t change with the number of loans we’re selling. It changes by the buyer’s appetite quite frankly, and obviously it changes as rates change.

Thank you all very much. I guess I would just reiterate that we’ve run the enterprise for 30 years almost through a lot of changes in market conditions and we’re very pleased with the overall performance of the enterprise last quarter and we’re going into the fourth quarter very strongly.

Thank you very much for taking time for our call.