First Citizens Bank: The Bank Buyers - [Business Breakdowns, EP.114]

28:50They've been trying to focus on more and more creditworthy borrowers. And that's partly a function of funding costs. Part of CIT's problem historically was that they had such high funding costs that they just could not make a spread going and lending to a AAA corporate, that you needed to take some level of risk in order to get a fair spread. And that's not a great position to be in. And it's not the one that First Citizens is in today, given their low -cost funding base. So they have been tailoring the CIT portfolio, pulling back risk on the margin. I'd expect something similar from Silicon Valley.

29:23A lot of it is very low risk. I think the capital call business where essentially you fund the capital going into a private equity or venture capital fund in advance until the ultimate client puts the money up, that's had something like one loss in the 30 -year history that SVB had been running it. So there are components where this very much fits with first citizens mentality. And then there are components like the early stage and growth stage lending businesses, where I wouldn't be surprised to hear about more of the up -tiering like we've heard about with CIT. I want to just hammer home that point on the cost of funds.

30:01And I think CIT is one that stood out. I can remember when Goldman was really trying to build up their asset base. They did something similar where it was way back when, when you needed a high -yield savings account. And most places were offering 20 basis points or 30 basis points. CIT and Goldman with their Marcus account had 160 basis points, or maybe you were getting a 2%. So what really drives that cheap asset base or low cost of funding for someone like First Citizens versus some of the others who are forced to pay to gather those assets? Well, in our view, the deposit franchise is really the primary differentiator of a bank.

30:45Lending, there can be specialized areas, there can be relationships, but a lot of it's commoditized and it's hard to have a real advantage through the cycle there. I think a lot of times in history, people have thought that they had an advantage only to realize that they didn't once there was a downturn. On the deposit side, if you have a great brand, if you have the right real estate footprint, if you're like the large banks where you can invest quite a bit into your technology and your app and provide a great experience, you can have a deposit base that will stay with you even if you're paying next to nothing in a high -rate world.

31:17That's what we've seen in meaningful portions of the large banks, and it's what we've seen in First Citizens and their footprint. First Citizens is less about technology than it is about customer service. They are very well aware, as Frank would put it, that they can't be the McDonald's of banking. They're not going to be the mass market, low -cost, undifferentiated provider. They are a bank where you walk in and someone knows your name, or you have a relationship with the banker for a long period of time. And in their markets, in North Carolina, especially where they've been for 125 years, they have a brand.

31:52A lot of times your first bank account is the bank account your parents opened for you, or you open at the bank where your parents opened. It helps to have been in that business, in those markets for more than a century. So they have the brand, they have the service quality and these relationships. And it's given them a very sticky depositor base that has been willing to provide funds at a very low price, even in this higher rate market. And we can see that going back through cycles and we've seen it through this rate period. And it's a major differentiator that, in our opinion, enables an excess return at a bank, that you have those sticky relationships that value you so much that they'll stay with you for very little yield.

32:33And historically, it's what's enabled for citizens to earn good returns despite a low -risk lending book. This is a more thematic question, Bill. You might be the right person to answer this. I think with SVB and the rate at which that run on the bank happened, especially compared to quarterly results, which showed there was a derace and mismatch and an interest rate exposure, but it seemed to happen very quickly. And you would not refer to those as sticky assets. Once it started, it happened very quickly. Do you think that that was a signal or indicative of anything having changed with the overall markets and the ability to move funds faster, technology and the way that information can spread?

33:17Do you think there's anything that happened with that event, which should be a broader concern for the overall system? It has certainly made all bankers attuned to how easy it is to shift funds. It doesn't mean getting in your car, driving to a branch, waiting in line. Instead, you're pulling out your iPhone and you move funds in seconds. But while there's been a lot of focus on how technology has made it easier for depositors to transfer funds out of a bank, I think the real thing here was at SVB, how much of the money was tied to the same industry and some non -financially sophisticated people who look to the same leaders to help them with their financial decisions.

34:03So you have one of those leaders tweet that he thinks people should move money out of SVB, and most of the depositors at SVB were probably followers of that person. I think where Alex has talked about first citizens having generational relationships, SVB couldn't possibly have been in a more different position. They couldn't make a reasonable estimate of how sticky their deposits were because they hadn't had them for long enough. When I was talking in the introduction about the three risks, credit risk wasn't a problem at SVB. Liquidity risk was a big problem because they had very liquid deposits and not so liquid assets.

34:48And then duration mismatch was a problem because the deposit side of the balance sheet floated completely with interest rates and the asset side did not. So one of the issues is not only the investment community, but also the regulators were so backward looking and thinking about banking risk that credit risk is what got all the banks in trouble in the GFC. So the focus on the regulatory environment has been on minimizing credit risk. And ironically, we've had some of the large bank managements that we've talked to post -SVB say that regulators were actually pushing them to extend duration by buying mortgage backs, just like SVB had done.

35:35So it's funny, you think about, you want to protect your capital base and you also want to protect your income stream, but sometimes those are at odds with each other. And the regulators were more worried about what would happen to the earnings of the banking system if low rates or negative rates persisted or came into being than they were about what happens if rates go from nothing to 5 % to 6 % in a very short period of time. So I think there are some pretty unique factors at work here, in addition to this technology change that's attracted all the focus of how easy it is now for people to change where they bank.

36:16Absolutely. Very interesting, and a lot to learn from that experience. With all that in mind, as investors, when you are generally approaching banks, I think you've referenced some of the metrics here in terms of ROE book value. How do you think about this as value investors yourselves? How do you think about the industry? And with all of those qualitative factors in mind and thinking about those when approaching any investment, how do you think about the actual valuation of banks? I think if you look at the past generation or two of where banks trade versus the S &P 500, they've typically sold at about two thirds of the S &P 500 multiple.

36:57We think that kind of make sense. I think it's hard to argue that this is a better than average industry and difficult to say why banks should sell at 18 times earnings when the S &P 500 sells there. But at Oakmark, we're always looking for opportunities of where prices get out of line with both their history and what we think fundamental value is. And today, the average bank sells at probably less than half of the S &P 500 multiple, so a larger discount than it has historically. And also, we would argue the industry itself is in much better shape than it was at the time of the GFC, especially regarding credit risk.

37:41We think there's unusual opportunity in banking. I mentioned earlier to us getting an opinion about the people in charge of various banks is one of the most important things because of the leverage and the opaqueness of the financial accounting. Capital allocation, hugely important. One of the reasons that we think the industry is more attractive today than it was pre -GFC is almost all of the leadership teams of the large banks agree that when they cannot grow at the rate they want to making loans to credit -worthy customers, they're all willing to grow by shrinking the denominator today. When there aren't organic growth opportunities, returning capital to the shareholders, both through dividends and share repurchase, is central to our philosophy at Oakmark that we want managements that are comfortable giving capital back to the owners when they don't have good growth opportunities.

38:38I think book value is a good starting point. A well -run bank ought to be worth book value. It's probably hard to get much more than twice that in terms of what the underlying value could be. And it's funny, I started in this business a little over 40 years ago. And one of the rules of thumb back then was that if you're looking at a bank, the PE should roughly equate to its return on equity. So if it earns 8 % on equity, it should sell at eight times earnings. If it earns 15 % on equity, it could sell at 15 times earnings. And through all of the changes in the past 40 years, and whether interest rates have been near zero or up over 10%, the math behind that very simple PE should about equal return on equity still approximately holds today.

39:32So for us, that's one of the other metrics that we would look at is how big a discount PE is available in the market relative to the return on equity the company is achieving. Alex, anything you would add just from a valuation perspective on First Citizens? I would just add that if you apply any of those metrics to First Citizens, you still get an attractive opportunity today. I think tangible book value jumped from $570 to something like $1 ,250 with this Silicon Valley bank transaction. The stock's just barely above one times tangible book value. A high return, reasonably fast growing bank like that, in our opinion, should be worth something closer to two times, which is where you've tended to see private market transactions take place for high quality regional peers.

40:21Same is true with the other rules of thumb that Bill talked through. If you think about deposit premiums on high quality deposit franchises and a 7 % to 10 % deposit premium, you'd end up with something like a two times tangible book value. You thought about an earnings multiple, you end up in that similar spot. So I think there's a lot of ways to cut it to see continued undervaluation, despite the fact that the stock's more than doubled in the last three months. One last thing I'd throw in there, Matt. First Citizens has two classes of stock. There's the regular class A stock that has normal voting rights.

40:57And then when Alex mentioned earlier that the family has about 40 % voting control, despite not owning nearly that much of the underlying share base, it's because their class B shares have super voting rights. And a strange anomaly in the market today is investors are so concerned about illiquidity that these super voting shares that don't trade nearly as frequently as the regular vote shares actually traded about a 10 % discount to the normal voting shares. So especially for individual investors who don't need to accumulate a large position to be meaningful to their assets and who can be in complete control of when they decide to liquidate a position in First Citizens.

41:47To us, to get paid 10 % to get extra voting rights seems like it makes a really good deal and even better deal. That's very interesting. Same dividend rights and everything else. It's just a matter of look, that explains that discount? Yep. When you look at the business model moving forward, there used to be these general rules of thumbs with where interest rates were and whether that would be a positive or a negative for the banks. Just thinking about First Citizens specifically, they have the acquisition and integration of the acquisition, which will, I assume, take some time to fully integrate and smooth out.

42:30But anything else that you think about as a key driver of the business model, and not that I'm asking you to make a rate call, but how important are interest rates in terms of impacting their earnings outlook and anything else that's a key variable in driving the outlook for the business? It's an interesting and ironic dynamic the industry's found itself in. For a really long period of time, through the 2010s, we were sitting here thinking, we need to get off this 0 % interest rate floor because the high quality deposit franchise and the low quality deposit franchise, they can both pay roughly the same amount when rates are zero.

43:10And the high quality deposit franchises as a result under earned. So there was this idea that higher rates would be extremely helpful because you'd be able to flex that high quality deposit franchise value and actually realize some of it by paying less than lower quality peers on your liabilities. That happened and you've seen meaningful net interest margin expansion for those banks. But now the industry has found itself in a different predicament, which is that the unrealized losses have increased so much from higher interest rates that at this point, it's not clear if the banks are still beneficiaries of rates being this high.

43:47And in a lot of circles for some banks, there's fear around what if rates go higher? Those unrealized losses could expand. First Citizens is once again here in a really different spot, partly owing to the Silicon Valley bank deal and partly from having managed the business differently going in. But with all the cash that they have on their balance sheet today, and with the fixed funding that they got from the FDIC, they're still asset sensitive. Higher interest rates would still lead to incremental net interest income. And they, as I mentioned earlier, are well above their regulatory minimum capital ratios even after marking that securities portfolio to market.

44:27So there's not the same risk of having those losses really become painful from higher interest rates. So on the margin, they'd still, I think, be better off with higher rates. Now, there's a lot of flexibility in that, and they have ways that they can replace that fixed funding that they have with floating if rates should fall, which means to some extent, by virtue of having all of these options that they got through the deal, they're able to have a heads I win, tails you lose type situation and maintain their net interest margin either way. Now, if rates go to zero, that will change. If rates went back to zero, it'll pressure the earnings profile, but it should still be meaningfully above what it was prior to these acquisitions and in the double digits in terms of return on equity.

45:12The biggest unknown driver that we're thinking about today in terms of First Citizens' Future Earnings Power is how much of the Silicon Valley bank deposits they maintain. This was a huge bank three months ago. And there's about $130 billion of deposits that were on Silicon Valley's books three months ago that are now gone. And there's some chance that the 41 billion of deposits that remain will continue running off. And First Citizens will have to pay those down and liquidate some assets over time to do so. That is an okay scenario. You still get the $700 something of tangible book value accretion.

45:51And that was real value created for shareholders. But we're a lot better off if we can maintain that $41 billion of deposits and actually grow it over time. So the big question is of that 130 that left and that 41 that's still there, can they win some of that back? Can they explain how this is now a safer bank, how it doesn't have the risks that SBB had, but still has that value proposition and service quality and start to bring some of that money back onto its own balance sheet. If it can, that 700 something dollars they added to tangible book value per share should be worth something much larger than $700 to First Citizens as you grow that earnings power off that base.

46:33An interesting dynamic with SVB was also that they were transacting or helping with the transactions. They act as somewhat of a capital markets participant for many of the companies that then ended up putting their deposits with the bank. Is that a business that they still plan to be in? It seems like it differs from First Citizen's traditional business. No, they did not acquire the securities business, actually. That was carved out. Interesting. And how important do you think that is? Because it did seem to be a big driver of deposit growth. And I think many folks often talk about SVB drowning in deposits, where you saw a period of time where many of these tech companies raised a substantial amount of capital.

47:17SVB was a key driver in helping those companies do that. And essentially, it led to them parking a lot of those assets at SVB. Just in terms of the overall system, it does not seem to be that important for First Citizens, given they seem to have a much different strategy towards asset gathering. But I guess when you think about SVB and the ability to hold on to those remaining assets. Is that a consideration in terms of their ability to do that? You mentioned the trust factor, but I just wonder how much of it factors into what the original reasoning was for those assets being with SVB. It's possible it matters and it's possible it matters quite a bit, but I'd emphasize that these deposits are down so dramatically from where they started.

48:02If two -thirds of the balances were attributable to the securities business, we've already lost more than two thirds. And so off of this base, it's less clear. And I think there's some room to absorb that having been a big driver. There's also components where it's clearly driven by something non -securities related. For instance, they have their winery business where they lend to winemakers and they publish a industry periodical magazine. They have all kinds of survey data. They have different ways of looking at lending to wineries than the rest of the industry thinking more about asset value than the cash flow that's differentiated them in that market.

48:39There's components of the value proposition like that, that are completely separate from the securities business that also matter. We don't know. I think the important thing from our perspective is that the worst case scenario is that you get the $700 or show of tangible book value coming back dollar good as you liquidated over time. The best case scenario is that they find a way to maintain or grow some of this, and it's worth more than $700. But we're pretty comfortable that we don't have to believe the latter in order to think the stock's attractive today. I think one of the interesting things in terms of trying to retain the SVB deposits, because of First Citizens' background buying banks the FDIC was selling, as Alex said, the day this deal got signed, First Citizens had people in California meeting with the important relationships managers from SVB, encouraging them to give First Citizens a shot.

49:36And in terms of that winery business, I read in an industry publication just last week that the relationship manager in charge of most of the wine business for SVB was encouraging the winemakers to give First Citizens a shot. So the chance that the observation that that individual has become an ally for First Citizens, I think is a very good sign as to the possibility that First Citizens will retain some of this business. That's consistent broadly with what we've been hearing from First Citizens, which is that they've had a big effort to reach out to former depositors that took their money out of the bank.

50:18They've been trying to rebuild those relationships, and they're seeing some encouraging signs. Now, it's very early. There's a wide range of outcomes, but they're seeing some signs of success in bringing people back to Silicon Valley Bank based on their outreach. Yeah. It's an interesting thing that a business very much seems to be driven by relationships. It's a contact sport and they understand that. So it makes them well -suited for that type of environment where relationships matter quite a bit. And most people are looking for someone to speak to, to understand things. Acquisitions have been part of the DNA.

50:53I think the bigger you get, the tougher it becomes to create future acquisitions and complete future acquisitions. Does that matter much? How do you think about their ability to do this more in the future? Does it matter if they are bigger and the acquisitions are just a smaller piece of the pie? How much is that core to your thesis, their ability to participate in some of these auctions and just acquisitions generally? It's important potential upside to the values that we were talking about earlier. I don't think it's required to believe that it's a cheap stock today, but it could be value additive.

51:29There are still every year going to be bank failures. And on occasion, those can be pretty large and they do have this competency. And so from time to time, can they buy one of these targets in a really capital light way? When they took over Silicon Valley Bank from the FDIC, they didn't have to put up a dollar. They were essentially given the loans at a discount. You're not issuing equity. You're not using all of your excess capital. It's a very capital efficient way to grow. And I'd imagine that this isn't the last one of those we'll see. It'll be hard to see them be this impactful as a percentage going forward.

52:04It might be tough under this administration, but there's potential for large bank M &A. I mean, they are far below that 10 % hurdle at which you're not able to buy any more deposit market share. At the 16th largest bank in the United States, there's lots of potential for mergers of equals. I do think that the recent crisis has shown the importance of size and diversification to the market and potentially to regulators. And that also could change how consolidation is viewed. I think they could double once more in size before they'd be top 10. Regulation, you mentioned it with banks. It's just a consideration at a very high level, and it could go in a million different directions.

52:47But how do you think of first citizens under the regulatory framework as being advantage, disadvantage, or neutral? And how much is regulation key in terms of de -risking the potential banking system or anything related to First Citizens? I think the biggest clear conclusion over the last decade or so is that the very largest banks have been disadvantaged. You've allowed all the smaller regionals, still top 25 banks, but global, systematically important banks. You've allowed all of those banks to run with meaningfully less capital, far less liquidity, far less debt, a bunch of different characteristics that enabled those banks to earn higher returns than the very largest banks.

53:32Obviously, the very largest banks came through this crisis, at least thus far, unscathed, and were actually net beneficiaries. So that playing field, it sounds like, will be leveled. Everyone is talking about incremental liquidity rules and incremental required debt issuance from the regionals, that will, to some extent, if that applies to first citizens, weigh on the returns relative to what they had earned historically. Now, the big offset is that they also did just bulk up and there are meaningful economies of scale in banking. And that's part of the reason that the large banks have been able to earn pretty good returns despite all of the headwinds that came from this incremental regulation.

54:11I think the returns will still be adequate. The industry will adjust if they aren't. But the difference between the first citizens of the world and the large banks, it seems pretty likely to narrow in terms of regulation. When I started in this industry, I think there were 14 ,000 some banks a little more than 40 years ago. And we have maybe 25 % of that number today, just over 3 ,000. I think both in politics and in the communities at large, people have a misperception that the small number of banks relative to what we used to have means banking has become more inconvenient. We actually have more than twice as many branches today as we had 40 years ago.

54:53So the distance somebody has to drive to their local bank has actually gone down. My hope is that from a regulatory perspective, and even just like a political perspective, that this drumbeat that we need to keep all the small banks independent, that that might die down. There are such strong economies of scale in banking that to earn the same rate of return, a small bank has to take incrementally much more risk, and it's not good for the system. And when the small banks get acquired, they inherit better technology, more economies of scale, better regulatory compliance. I think it's actually good for the system to see more mergers and acquisitions in banking.

55:44And people say like, oh, wouldn't it be awful if we got down to a world where we only had 120 banks in the United States? I'm not so sure why that would be a bad thing. You answered my question there. I was going to ask you what you thought the threshold might be where it tilts unfavorably to the system. Certainly, there are many examples of countries outside the United States where they have a much smaller number of banks per 100 ,000 in the population, and it doesn't seem to be creating any negatives for them. Risks. I think we've talked about risks throughout the conversation, but if you were to isolate the most important risk for citizens, what would you identify?

56:29A handful. I think that the management here has created so much value over time. There is, to some extent, key man risk that comes with that, especially having the bank being family control. Now, Frank's been pretty clear to us that it's not necessarily going to be a family member to take the helm after him, that he said, we all have way too much money invested in this thing to let an idiot run it. I feel reasonably comfortable with him making that decision, but it's hard to imagine them finding someone that will add as much value to the company down the road as he has. More broadly, the bank's increased its size very rapidly.

57:07That comes with needs to integrate risk systems, liquidity management systems, all types of different reporting mechanisms. And it comes with incremental burdens in terms of stress tests. And there's an element of execution risk associated with that and regulatory risk that to the extent that some of those systems are not up to par, you'd likely have the Fed in some way respond. I think that the risks that most people talk about today for banks, like the mark -to -market on securities, really aren't that meaningful here. I think most of the other banking risks like credit that we've covered in this conversation aren't that meaningful.

57:43And so it's a very different set of considerations than it is for most of the banks that investors own today. One closing question on the interest rate. dynamics, which I didn't ask before, is you have the change lower to higher, but then also the speed at which it changes and the volatility within interest rates. Is more volatility better or worse? And I frame that within the context of we had this low interest rate environment for such a long period of time that a large percentage of those books have adjusted towards being consisting of very low interest rate environment loans. Does the speed at which that changes have much impact on the risk to the banks?

58:27If the latest rate increases had happened more slowly, you wouldn't have the mark to market issues to the same extent that you have today because more of it would have matured. On the other hand, with more time comes more time for deposit costs to adjust. So it's a mixed bag. I think the volatility, there's a big difference between 400 basis points of volatility of rates going from two up to four and then back down to two compared to one -way volatility where they go from two to four and then to six. And I think the magnitude of the change that we've seen in the past year, along with how rapidly it happened and that was all in one direction really was like a perfect storm for the companies in the industry that thought they had more stable deposit bases than they actually had.

59:18You answered the question that I should have asked, which is, if it had gone slower, what would have been the difference there? So that's excellent. We close these conversations out with lessons that you might be able to take away from looking at the business and apply elsewhere as an investor. Does anything stand out for First citizens in terms of a lesson from looking at this business that you think applies more broadly? I think one of the strongest lessons here, and it's something that is important across Oakmark's investment philosophy, regardless of the industry we're investing in, is investing with managements that think long -term and behave like owners rather than professional managers.

1:00:01I think the focus here on maximizing growth in long -term per share tangible book value, and it works here because tangible book is such a strong correlation to true intrinsic value, was a real separator for first citizens over the past decade and also sets up well for them as we look going forward. When we first bought this stock, it wasn't even in our set of possibilities that they could do another acquisition that doubled their scale and doubled tangible book value when they did it. But when you align with managements that have skin in the game and behave like owners, the things that you can't model tend to skew to the very positive side.

1:00:50And we've been a beneficiary of that at First Citizens. And I think investors over the next decade will continue to benefit from that. I would just add from a director of research perspective, there can be a lot of group think in the investment world. And there's all these communities of investors and social media and various names become in vogue and not in vogue at various points in time. And there are hedge fund dinners where everybody's sharing their best ideas and the ideas percolate through the system. And this is a company that was not on anyone's radar, wasn't brought up in these idea dinners, didn't have long threads on Twitter.

1:01:30And it emphasizes, I think, the value of really doing your own work and just turning over rocks, trying to find the best opportunities, even if that's not something that is being written up on all the popular websites and talked in the investing communities. There's real value in that. I still think it's amazing that we were one of the very few active value managers that owned this stock prior to the Silicon Valley bank deal, when it was already such a large bank with such an excellent track record. It tells you something, I think, about the sourcing process and different ways to create value.

1:02:05I think you're 100 % right. I can attest to not being familiar with this name and almost being embarrassed when we started discussing the research for this one. And I think you hit it on the head there. Bill, Alex, this has been an excellent discussion, a timely discussion, not just on First Citizens, but overall on the banking system. Thank you very much for joining us. Thanks, Matt. Thanks. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joincolossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S dot com.