Hingham Institution for Savings (HIFS) - AGM 2024
Collection of quotes from the Gaughen father-son management team
We reviewed Hingham Institution for Savings’ 2024 annual general meeting (“AGM”) which was held on 25 April 2024. We often try to listen to strong management teams to learn from their strategies and philosophies on how they run their companies. You can watch the recording of the AGM here.
Here’s a collection of quotes from the Gaughen father-son duo:
Low-cost leadership and operating leverage
The source of that efficiency is both structural and operational. Game selection being a structural choice, so what businesses do we choose to operate in, and more importantly, what businesses do we choose not to operate in? Operational being game play, once we've made those decisions, how do we play? So how do we run the business, are we able to effectively leverage the best people and technology and adopt a frugal approach to costs?
We talk about being relentless and taking unnecessary costs out of the business and this is occurring all the time, every year, in good times and in bad times. And I think it's important to note that doesn't mean cost cutting. It certainly can, but the critical thing is getting operational leverage on the expenses so it's not a matter of outright reductions in cost. It's a matter of figuring out how do we run the lending and deposit businesses in a high-quality way, identifying high-quality assets, originating them, servicing them, seeing them repaid, operating a deposit business that delivers unique value to our customers. And do that in a way every year where we spend a little bit less as a percentage of the total balance sheet, every year, year after year. While the total amount that we're spending may certainly grow in any given year, it's that leverage that's the key piece.
I think one of the things if we were to set the efficiency ratio aside, and we were to set the non-interest expenses a percentage of the total balance sheet aside – if we're to just think about the number of people that are on the team at Hingham, the total FTE count right now is, I think 87 or or 88 people on the team. When we came to Hingham 31 years ago, that was probably between 50 and 60 people. And the bank is about somewhere between 35 and 40 times larger, with a very different footprint operationally, clearly more offices from a retail perspective and a very different commercial presence for our customers on the loan side and on the deposit side. I think that speaks to the leverage that the business has when we have great people, when that's supported by technology, and obviously there have been changes in the industry since then as well.
Relationship building lowers the cost of making incremental loans
I think when we think about the relationships that we build with customers, as we make loans, we also gather deposits. And as we make loans, we lower the cost of making the next incremental loan…
…If we were to look at the largest relationships we have from a credit deposit standpoint, they tend to be very longstanding. There are relationships with individuals where we've banked their family over a longer period of time and I think we're likely to continue banking them over a longer period of time. You know, there are a number of families where we've seen at least one or two generational transitions.
And when we do that, I'd love to do more of that, but when we do that, that business is particularly profitable because we tend to have every aspect of that customer's banking business. Maybe not every loan, there's something that goes elsewhere because it doesn't fit with what we have, but we have the core deposit relationships and we have I think a sense from a credit perspective, over time those borrowers know what they're doing and that's not something that's measured quantitatively.
…I don't want to name the individual customers, I'm trying to hold back on that, but there are customers where, based on a long track record of experience, we we're still very focused on the assets, but we have a lot of confidence in their ability, in their kids’ ability, to manage these assets and run them profitably. And when we think about the cost to acquire, the cost to underwrite, the cost to put those loans on the books, and the cost to service those loans, all those different costs fall when we have better information about our customers.
…with respect to multifamily is that we're lowering in some ways our future costs of doing business with them whether from a credit standpoint, or from a sort of back office non-interest expense standpoint…
…If I were to think about a loan, I'm thinking about one relationship where every deal we've done with this individual and their family, they all look very similar and the buildings – it's the same paint, it's the same trim. They deliver a phenomenal product for his tenants and his kids are involved and it's a great long-term customer of the bank and there's going to be a loan proposal. We're going to look at it, the executive committee, we're going to run third parties, we're going to appraise that piece of collateral, probably we're not going to have environmental given what he does and where it is, but we're going to send it to our attorneys, we're going to structure it. It's going to be the same docs that we do a 200 unit building with so there are no shortcuts there.
But on the other hand, it's probably a five to 10 second conversation between Sean Sullivan, who's sitting in the back here, who manages that relationship and my dad or myself, “So and so is looking at this property, it's on this street it's next to the other one that you did, you remember?”, “Yeah, I remember that building, and here are the basic economics”, “Yeah that sounds right okay, let's do it”. And that was that was the whole thing and that went right back to the customer and it didn't take any longer, that was honestly probably much more efficient than me prattling on for five minutes on this topic. And I think there are real benefits to that.
Loan quality is the real bank killer
The first thing that I think about when I get into work in the morning is the loans. The very first thing I do after I'm on the system is look at the daily past due list. I want to see, “Is there anybody who's late?” and to the extent that I don't sleep well and it has to do with business, it's always thinking about the loans – credit risk kills banks.
There are certainly exceptions to that, I think in the last year we have seen a few of them, but over a long stretch of history the bank killer, the real bank killer, is credit quality. It's loan quality. Because that's the thing that triggers issues elsewhere in a bank's financial statements. That continues to be a challenge, the environment that we see around us in terms of the commercial real estate markets is one where there are a lot of opportunities for us, but there are clearly a lot of difficulties that other banks are facing. And we certainly can't imagine that we'll be immune to those forever, so that's something I think we're very attuned to, how do we look at those loans and identify incipient problems and issues that might be arising.
Commercial real estate portfolio quality
It's been, I believe 13 or 14 years since we've charged a single dollar on a single commercial real estate loan.
…we have no non-performing or non-accrual commercial loans. None. Not one. Not one dollar. There are about 1,700 commercial loans that we have in the bank and not one of them is non-performing. Not a single one, not a single basis point.
We have no delinquent commercial loans. So delinquency is established at 30 days and you can see that if you look at a bank's call report – those loans are often carried as performing probably out until 90 days, but we don't have a single one. Not a single loan, not a single dollar.
We are not in the business of modifying loans. We're not in the business of extend and pretend. We know that when we bought that risk at the outset. We've done so with strong borrowers with very substantial equity cushions and with loan structures that are protective.
Of the $3.5 billion in commercial loans as of today, there's a single loan for $460,000 that's currently 15 days past its due date. And I have to confess that I wrote these slides yesterday, there's a decent chance that that fella paid today, because the loan's probably 12 years old at this point.
The competitive threat of J.P. Morgan Chase in the San Francisco market considering their takeover of First Republic
I think one of the things that I talked about last year that I was clearly incorrect about was the rapidity with which we might be able to exploit some of the challenges in San Francisco after First Republic's failure. I don't think I was wrong about the substance, but I do think I was wrong about the timing. And in part that was because when J.P. Morgan Chase acquired First Republic in May of last year, I think they were wise to not immediately start to merge the bank into sort of the big Bank of J.P. Morgan. That was true on the deposit side, it was true on the loan side. I think they were initially careful about the relationship that they had with staff of the bank and I think the product of that, probably across all the markets, certainly San Francisco, was that we didn't see kind of a wholesale fragmentation of the customer base and the team, at least early on.
I think over time, J.P. Morgan, obviously, I think an outstanding bank in a number of respects, but also very large, I think it has been difficult for them to retain a lot of the best staff. There are a number of folks that have joined us that are phenomenal, I don't want to speak for them. And there are a number of folks that we continue to have conversations with, coming from First Republic, where the client focus that had made that a place that they enjoyed working was less present at J.P. Morgan Chase. The ability to solve problems for customers was diminished. And over time, the natural friction that customers have, it started to increase as they were dealing with J.P. Morgan Chase itself.
And now that we're almost a year, I think it was May from the acquisition I think we're starting to see some of those trends accelerate in a number of different ways. I think that's true in the lending business, I think there are probably other reasons for that, but I think one of the things that we see is that there are customers where it's very difficult for them to get answers. I mean, their Banker might have moved on or it's hard for the replacement contact to navigate the bank. So I think we're going to continue seeing more of that in terms of lending customers, in terms of deposit customers, in terms of folks that would be interested in joining our team and we would have an interest in speaking to.
Having said all of that, J.P. Morgan Chase is a ferocious competitor on small multifamily. That's true across all the markets and it's likely to continue to be true in California, where they had a substantial presence even before the acquisition of First Republic. If it had been up to me, probably would have preferred that someone else bought First Republic, but we play the cards that that were dealt. And given our size relative to the size of the markets that we're talking about, in Boston or San Francisco, First Republic was never present in Washington materially, I don't think it materially impacts what we should be able to do with customers and with teammates.
Hingham’s model doesn’t require low interest rates; what matters is a positive spread and ability to lower costs
It goes to whether the ability of the bank to generate returns in the mid-teens was something that's simply a function of very low short-term interest rates. Occasionally I’ve heard from some that they believe that to be true – I think that's really not true. If we look back over the last 30 years, if we looked in five-year segments or 10-year segments, there has been a production of returns in the teens, sometimes high, sometimes mid, sometimes low, occasionally below 10 in the inversion years, in the mid-2000s and certainly last year as well.
And so, there's been differences over time, but in a number of different interest rate environments where short-term rates were high, were low, were somewhere in between, the bank was able to deliver those returns over time, was impacted in particular by volatility at the short end of the curve. So that that was a problem if we look at 2006 and 2007, clearly been a problem, in the last 18 months to two years.
But the core competitive advantage, to the extent there are any competitive advantages in banking, which as we've previously discussed, it's kind of a dreadful business in the sense that it's very competitive, there's no protection of intellectual property, we're not a sole supplier to anyone, to the extent that those advantages don't exist and it is largely a business in which people are taking price on both sides, I think over a longer period of time the ability to take cost out will be a driver of returns, whether interest rates are low or high.
And that's true even if short-term rates remain high, that obviously makes the path towards mid-teen's profitability a different one than if we were to see some change at the short end curve. But I think over a longer period of time, it is not something that depends on shorter short-term rates to the extent that if we look at short-term rates and we look at the five-year point on the curve, over a long period of time, the average positive spread is probably been somewhere between probably around 125 basis points, give or take a little bit, and on that we layer on 200 basis points to account for cost and credit maybe a little bit more depending on the environment and net of cost paying taxes levered 10 times, to keep the math easy, you see a return that's in the mid-teens.
And that is true whether short-term rates are close to the zero bound as they were for a long period in the teens, or quite a bit higher as we saw in the in the aughts or in the late 90s. And to the extent that we are considerably more efficient now than we were five years ago, than we were 10 years ago, than we were in the early aughts, when there was a period of what we could say was higher for longer, when we were nowhere close to the zero bound, to the extent that we're considerably more efficient now I think that that positions us really quite well.
We have, I think, real doubts that over a longer period of time the spread between the market price for money and the price that banks pay is likely to persist. So in a higher rate environment, “higher rates for longer” so-called environment, our market rate funding – we're paying what we're paying. There is no catch up there, no catch-up beta; but the gap between that and what we see out in the environment is a significant one.
I think that we have not seen a higher for longer rate environment in which there was the ease of switching, there was the transaction cost that we see now in terms of searching for alternatives in terms of opening new accounts. And so consumers that may have stayed put in prior rate regimes like that are looking at alternatives. And when they're looking at alternatives, I think that we're well positioned for that and because of our cost advantages, we can absorb that.
As we've seen over the last two years, it's been a very difficult period, but we have also done mid-single digit returns on equity, and last year was actually quite a bit higher. And so I am not as pessimistic about that, I don't think that the model requires low rates. It does require some positive spread, that is important, whether that's achieved by changes at the short-end or the long-end. Over time, it doesn't matter; in the short end, obviously the short run. I'd obviously prefer it to probably be achieved in both ways, but structurally I don't think it's a challenge. And I think the cost advantage is something that everyone will need to develop because the competitiveness for that low-cost funding is going to continue.
Why Hingham’s spreads are increasing over the last 1-2 years
It has probably been the case that the spreads that we're achieving over the underlying rates have increased over the last one to two years. And I think that's true of the market. I think there's probably there's at least two reasons for that…
One is that traditionally everyone has priced off the belly of the curve, so has priced against a five-year treasury or home loan bank advance in pricing their multifamily loans. As the curve has inverted, that spread to that point on the curve has been insufficient, so I think one of the things that everyone involved in the business has done is see spreads expand. And they're doing that because they need to capture back to the inversion and then they need to account for credit their own profitability.
…the competitiveness of the market has changed particularly in the last year.
There are fewer folks that are lending there and when they hear commercial real estate, they're not interested, or they hear office – and you could be lending on the White House, and the loan committee would say no.
Asset and liability management: Marginally increasing asset sensitivity
There are some things that we've done over the last year and a half in terms of the new business that we're writing that I think over time will make us marginally more asset sensitive, which I think is what we're aiming for. We're not looking to substantially change the structure of the balance sheet and the notable thing there is historically we've written five-year multifamily loans and they tend to have five-year options. So, they're priced for five years, and then they reset to a margin over an index, typically the Federal Home Loan Bank, they're fixed for another five years and then at the 10-year point, it resets again.
One of the changes that we made is everything starts adjusting annually, after that initial period. And it's mainly because borrowers don't give us new prepayment protection in the adjustment legs on those loans. And what that means is there's a certain asymmetry in the risk and return that we take when we face those customers at adjustment. And since we made that change, we've really had no push back so that's not a this-year thing or a next-year thing but over time, we think that's probably likely to make the asset side of the balance sheet slightly more responsive.
Capital allocation: Benefits of minority equity investments…
There are some businesses on this list [referring to the slide 6 titled “What We Don’t Do”] that we actually do have economic exposure to in our equity portfolio and one of the reasons that we don't do those things but may invest in them indirectly, insurance is a particular example and probably payments, is that they can be very good businesses. There are people that run good businesses to the extent that we can get exposure to that and learn from them in those minority equity investments and we don't take on the operational expense of running the business ourselves and I think probably more importantly, we don’t have the hubris or arrogance to believe that we can do a good job at those things. We get to benefit from the work of some outstanding management teams running some great businesses and it shows up over time through the value that's created for our shareholders, so when that’s done on a on a minority basis, there's no control premium paid.
… and the disadvantages of control equity investments
We continue to think that, for the most part, the acquisitions that are pursued in the industry are value destructive over time and that the cost synergies that folks identify don't materialize. The impact on the bank's staff and thus indirectly the bank's clients can be a very negative one.
There's a long track record of that, looking at empirical data, in terms of the industry performance, there are a handful of banks that have done a great job, but they're the exception to the rule. And when we've seen this in the markets in which we're active in, I think particularly in Boston and in San Francisco over the last year, given some of the events we've seen with the failures or with some of the announced mergers I think we can see that impact tangibly in terms of the impact on staff on customers and ultimately on results for the owners.
On stock buybacks
I think we continue to believe that in the current environment the incremental return on the lending business that we're doing, given the pricing that we're obtaining on it, even if we were funding that at market rates, and even if we were assuming that we were match funding it with two- or three-year money in the wholesale markets, those returns are fairly attractive right now. And they continue to exceed what we think the return would be strictly from repurchasing.
Disclaimer: Please note that none of the information provided constitutes financial, investment, or other professional advice. It is only intended for educational purposes. I have a vested interest in Hingham Institution for Savings. Holdings are subject to change at any time.