Why Schwab panicked about regional banks

Why has Charles Schwab, the nation’s largest public brokerage firm, a financial giant with $7 trillion in assets and 35 million accounts, swept up in the recent banking turmoil?

It’s a question that has left many scratching their heads in recent weeks, as the sudden collapse of Silicon Valley and Signature Bank also destroyed Schwab’s shares. Since March 8, when the Silicon Valley bank stunned investors by saying it needed to raise cash, Schwab shares have fallen 31 percent.

The reason is twofold. Although Schwab is best known for its core business of offering trading and investment accounts, its outsized operations include what may be the country’s 10th largest bank, which had $367 billion in deposits at the end of last year. But the bank also held $28 billion worth of bond losses on paper at the end of 2022, in a frightening parallel to a Silicon Valley bank, which held similar securities but was forced to sell them at a loss when depositors demanded their money.

“Investors often shoot (sell) first and ask questions later,” Stephen Biggar, director of financial services at Argus Research in New York, said in an email. “Schwab’s initial concern was with the amount of deposits invested during a low interest rate period and therefore currently being held at a loss. But Schwab does not have the other areas that led to the decline of SVB.”

Bond losses are a product of rising interest rates: Some in the financial services industry did not anticipate how quickly the Fed would raise its key rate while trying to contain inflation. Many banks hold long-term bonds with low interest rates, which are becoming increasingly unattractive as the Federal Reserve raises interest rates and new higher-interest bonds become available. But as long as the banks undertook to hold those old bonds until maturity, for accounting purposes, the lower values ​​showed up as unrealized losses on their balance sheets.

The real problems arise, as happened with SVB, when those investments must be sold to meet withdrawal requests from depositors. Schwab executives have gone to great lengths recently to reassure investors that it’s something they won’t need to do.

The chance is close to zero

in A recent note To clients, employees, and investors Charles Schwab, the brokerage’s founder and co-chairman, and Walt Bettinger, co-chairman and CEO of the firm, went so far as to say there was “near zero chance” of resorting to selling those investments.

However, the unrealized losses—largely in mortgage-backed securities and Treasury bills—were enough to scare off investors. Schwab’s stock closed Friday at $52.38, down from $76.20 on March 8, two days before the federal government shut down SVB. It’s down nearly 44 percent, from $93.16 on March 29 last year.

Silicon Valley, which was the 16th largest bank in the country, failed after depositors withdrew their money because they feared they could lose it all if they didn’t. The majority of SVB clients – mainly startup founders and venture capitalists – keep large sums of their money in the bank, exceeding the FDIC’s $250,000 insurance limit.

In contrast, Schwab’s deposit base is made up of retail customers, and 80 percent of that money falls under the FDIC cap, alleviating any concerns that their deposits may disappear.

“Schwab should never have to change those unrealized losses into realized losses by selling securities, because it has great access to cash,” said Michael Wong, Morningstar’s director of equity research and financial services.

Mr. Wong said the company has access to the Federal Reserve’s new emergency lending program, which could provide it with more than $200 billion in cash to handle potential deposit withdrawals by customers. It also has about $40 billion in cash on its balance sheet at the end of 2022, Mr. Wong added, and more than $50 billion in cash is expected to arrive this year, according to his calculations, as well as other sources of liquidity. .

Profits concerns

But while Schwab may have access to a lot of capital, he said, the company’s earnings will be lower than previously thought because the cost of borrowing increases as interest rates rise: a company usually resorts to its own deposit base of funds, but this may It happened. It is steadily shrinking as clients move their money into more profitable accounts with higher returns.

As a result, more stock watchers became increasingly pessimistic in their predictions about Schwab’s outlook. Since the beginning of the year, so have Wall Street analysts cut steadily Their earnings estimate for the first quarter: The consensus estimate was lowered to 94 cents a share from $1.09 in January, according to IBES data from Refinitiv, a provider of financial markets data.

Like many financial services companies, the brokerage giant has had to adapt quickly to high interest rates. More than half of Schwab’s total revenue last year came from so-called net interest income: Most of that comes from its customers’ uninvested cash.

Schwab would pay clients interest of, say, 0.45 percent on their assets and then invest the money at higher rates. Then the bank pockets the difference. But as customers transfer those deposits into higher-yielding accounts at Schwab or elsewhere, Schwab’s bottom line is likely to suffer.

Schwab Bank, which it added in 2003 to provide customers with more products and services such as basic checking and certificates of deposit, operates a little differently than most traditional banks. Lending is only a small part of its business. Instead, it invests most of its clients’ deposits in safe government securities.

The company, which has been a leader in discount investing for more than 40 years, continues to push the boundaries of retail investing. In the fall of 2019, it eliminated all trading fees on stocks and exchange-traded funds. Months later, in another bold move, it acquired its main competitor, TD Ameritrade, overtaking Fidelity to become the largest brokerage firm, according to Cerulli.

The rest of Schwab’s revenue is generated from trading, asset management and other fees derived from its brokerage business. Given all the turmoil in the financial markets, investors will be closely scrutinizing first-quarter earnings reports from Schwab and other financial institutions — which will be released in April — for any worrying signals.

“Just like much of the financial sector, there is a lot of uncertainty,” said Morningstar’s Wong.