Charles Schwab
Should we want to talk to Chuck? Probably not. I bet he's grumpy after losing so much money over the past week.
The Company
If you’re not familiar with Charles Schwab, they describe themselves as a savings and loan company. They’re primarily a securities broker, but the business also includes banking and wealth management services. They’ve been around since 1971 and have over $7 trillion in assets.
I know, the banking thing scares everyone right now, so let’s take a quick look at how big that piece of the business is. In the most recent 10-K Schwab says they have the following client accounts:
33.8 million brokerage accounts
2.4 million corporate retirement participants
1.7 million banking accounts
Like I said, primarily they deal with investment money.
Schwab is well known and has a strong brand. It’s the second largest securities broker, behind Vanguard. For their size, Schwab has done a pretty good job of staying out of scandals. You won’t find fake accounts or other Wells-Fargo type shenanigans at Schwab. They claim to try to see everything “through client’s eyes”, meaning that they base decisions on the golden rule. Nice.
From my research, this seems to have some merit. In his letters to shareholders, CEO Walter Bettinger makes multiple references to doing things with a long-term and customer focus, even if they’re harmful in the short term. Most recently that has been integrating the TD Ameritrade merger slower than they could have. It’s cost Schwab some money to leave redundancies in place, but it’s going to make the transition smoother for TD Ameritrade clients and will also give Schwab time to ensure they create the best possible combined business. I like to see that sort of thing from a CEO.
The Business
Now that you know what they do, how do they actually make money? Schwab focuses a lot on reducing operating costs without reducing the quality-of-service clients receive. They also like to drive down costs for their clients. In 2019, Schwab was the first broker to go to a zero-commission model. They forced their competitors to do the same, ending a centuries long source of profit for brokers.
So, if they don’t charge commissions on most trades, how do they make money? Don’t get scared, but a lot like a bank. Schwab pays a teeny tiny amount of interest on money deposited in brokerage accounts, then loans that money out a higher rate. They get to keep the difference in the interest rates. If you’re familiar with the banking business, you’ll recognize this as net interest income. As of the end of 2022, this was 51% of their income. They also invest their cash in relatively stable, and safe securities to generate profit - like treasuries. I know, it sounds scary right now. We’ll get to that in a minute.
There are some other places Schwab makes money - there are still commissions on products like options and futures. They make money in their advisory services. They have some funds that have fees. They also make some money from their banking business through fees and services. This is where the other 49% of revenue comes from.
The Panic
It’s been just over a week since Silicon Valley Bank collapsed and sent investors and depositors into a panic. If you’re not familiar with what happened, here’s a quick summary:
Silicon Valley Bank was a regional bank that catered to tech startups. All kinds of tech companies banked with them - from brand new ventures with less than 10 employees to companies you’d recognize like Roku, and Roblox. More than 90% of them had huge accounts, well over the $250,000 FDIC insurance limit. Roku had just under $500 million there. As tech slowed down, companies started withdrawing more money than usual to feed their cash burn. Eventually SVB had trouble coming up with cash as quickly as these companies would like. Like all banks, SVB loans out deposits using fractional reserve banking - the money doesn’t just sit there waiting for you to come get it. Word got around Twitter that SVB didn’t have any cash and sparked a panic. More companies went to try to get their money from SVB and a classic bank run was on.
To get cash, SVB had to sell some of its assets - long dated, low yielding treasuries bought in the days of 0% interest rates. Since the FED has raised rates at the fastest pace ever, these weren’t worth much. SVB took losses, sparking more panic and more withdrawals. They attempted to sell shares to raise capital, that failed, and the FDIC took over the business. The pertinent details here are:
SVB was highly concentrated in tech startups. These companies are known to burn cash - meaning that big withdrawals should be expected to go along with big deposits.
SVB had a lot of customer accounts that were over the FDIC insurance limit.
SVB didn’t have the liquidity to meet the increased pace of withdrawals and was forced to sell assets at a loss.
The SVB collapse was followed by trouble at Credit Suisse and issues at First Republic bank which set in motion a major sell off in most bank and financial stocks, Charles Schwab included.
Why’s Schwab Different?
Schwab Isn’t a Regional Bank
In 2018 regulations were eased for regional banks, who argued that they were too small to put the financial industry at risk. The leaders of Silicon Valley Bank were some of the loudest voices making this argument.
Charles Schwab isn’t a regional bank. They’re the 11th largest bank in the country and subject to heavy regulation, capital reserve requirements, and oversight by a list of agencies.
Schwab Is Mostly a Broker
Go back and look at the account numbers again. Less than 5% of accounts at Schwab are bank accounts. The rest are brokerage and corporate retirement accounts. People don’t put cash they might need soon in brokerage accounts, and retirement accounts are restricted until you get to retirement age. The risk of massive withdrawals at Schwab is much lower than at a bank catering to businesses known to lose money. In fact, during the week after the SVB collapse…
Schwab Has Seen Cash Inflows
Schwab has received $16.5 billion in deposits in the week since the SVB collapse. They’ve taken to calling themselves a “safe port” in the banking storm. Combine that with the fact that over 80% of accounts held at Schwab are fully FDIC insured and it would seem unlikely that they’re about to experience a bank run like SVB did. Even if they do see more withdrawals…
Schwab Has Liquidity
Schwab has access to over $80 billion in borrowing capacity with the Federal Home Loan Bank (FHLB), which is an amount greater than all their uninsured deposits. In addition, Schwab thinks they have about $300 billion in total borrowing capacity from the new Federal Reserve program and other short-term lending programs. JPMorgan Chase analyst Kenneth Worthington issued a research note on 3/15 saying that with the BTFP now in place, liquidity concerns in the near term have been "significantly de-risked if not outright eliminated for the next year."
But What About the Balance Sheet?? HTM, AFS, AOCI and More…
All the panic around SVB has made investors look more closely at balance sheets for financial companies and banks. Most banks hold a lot of treasuries, and most treasuries bought in the past few years are down in value because of rising interest rates. Banks can designate securities as available for sale (AFS) which means they can sell them at any time or held to maturity (HTM) which means they are not planning on selling them.
Schwab does have massive unrealized losses on treasuries in both the AFS and HTM portfolios, but these only really matter if Schwab is forced to sell them. As we’ve already seen, Schwab is unlikely to see massive withdrawals and has significant liquidity if they do.
What About AOCI?
For accounting purposes, AFS securities are carried at fair value. Unrealized gains and losses are reported as increases or decreases under accumulated other comprehensive income or AOCI.
There is a fear that AOCI doesn’t adequately show the financial position of a company like Schwab because it doesn’t take into account unrealized losses on HTM securities. In fact, if you take those losses into account, it wipes out nearly all of Schwab’s tangible equity. People using this argument are trying to imply that Schwab is close to insolvency. People making this argument also like to point out the $173 billion Schwab moved from AFS to HTM last year. They imply that this is to hide the unrealized losses in the HTM portfolio because Schwab is in such bad financial shape.
To unravel all of this, we need to talk a little bit about accounting. There is a massive difference between GAAP equity and the realities of running a business. There is also a difference between GAAP equity and the regulatory capital requirements Schwab is subject to.
The most restrictive regulatory capital ratio - the Tier 1 Leverage Ratio doesn’t count losses on AFS securities until they are actually realized - either through sale or credit impairment. Because the securities are backed by the US government, credit impairment losses are pretty much off the table. At year-end, Schwab reported $40bn of Tier 1 Capital against $567bn of assets, for a Tier 1 Leverage Ratio of 7.2%. The minimum capital requirement is 5% so there’s a $12 billion buffer that exists before Schwab is in trouble.
If Schwab did see significant withdrawals, it has $40 billion in cash. There is also $22 billion in securities with <1 year remaining, meaning they would sell at essentially par value. They’ve got another $80 billion in borrowing capacity from the FHLB. So there’s $142 billion before they even have to think about touching the AFS portfolio at a loss. Even if Schwab didn’t have access to the full FLHB loan and had to sell securities at a loss, once you take the deposits and assets off the balance sheet, the Tier-1 Leverage Ratio actually improves, increasing the $12 billion buffer and allowing Schwab to take the loss without getting close to the 5% requirement.
So, Why’d Schwab Move Securities to HTM??
Because even though the regulatory ratios don’t count unrealized losses on AFS securities, borrowing requirements for the FLHB do. To have full borrowing capacity from the FLHB, Schwab had to move securities from AFS to HTM. It wasn’t some dubious move to hide losses. It was good management to increase liquidity. Schwab has been monitoring the trend of people moving money out of lower yielding accounts into higher yielding assets like 90 day t-bills. By the way, their assessment of this trend predicts that “cash sorting” will decelerate as rates stabilize. It’s widely expected that we’re close to the Fed’s terminal rate, so withdrawals due to “cash sorting” should be continuing to decelerate, then stop when the Fed pauses rate hikes.
Other Balance Sheet Concerns
The other risk I see to banks due to rising rates is commercial real estate loans. Most commercial loans are either adjustable rate loans, or shorter term than residential. Think 5 and 7 years. With the shift to work from home, lots of commercial space is still empty or underoccupied. When low interest rates are refinanced higher, I think there is a lot of risk of defaults on commercial loans.
Schwab does not have exposure to commercial real estate. Looking at their 10-K, their bank loans portfolio is made up of first lien residential loans, HELOCs, portfolio asset loans, and “other loans”. The residential mortgages are high quality with the vast majority of borrowers having FICO scores of at least 740 and the majority of mortgages at 70% or less LTV.
So the loan portfolio doesn’t raise red flags for me at this point.
What’s It Worth?
Ok, so hopefully by now I’ve laid a lot of your concerns to rest. Now we get to the question of valuation. Just because Schwab stock got hammered in the last week, it’s not necessarily at a good price. Maybe it went from ridiculously overvalued to moderately overvalued. That’s totally possible in this market.
DCF
Schwab’s TTM EPS is $3.50. Analysts expect just over 16% growth over the next 5 years. Given the company’s past performance, I don’t disagree, but just to be a little conservative, I’m going to knock that down to 15% growth. Using a 10 year DCF with a PE of 30 and a WACC of 15% (if it’s not going to return 15%, I don’t want to own it) I get a fair value right around $105.
Schwab closed at $56.41 on Friday, so it does seem to be on sale.
Insider Buying
If I haven’t convinced you, maybe the insiders will. CEO Walt Bettinger bought $2.97 million in shares this past Tuesday. The CFO bought almost $300,000 in shares. Directors are buying too. Todd Ricketts bought over $500,000 in shares. John Adams bought almost $300,000. Stephen Ellis bought $2.3 million worth, and Mark Goldfarb bought $233,000 worth of shares.
As Peter Lynch said, there’s lots of reasons insiders sell, but the only reason they buy is because they think the price is going up.
My Plan
I didn’t have any prior knowledge about Schwab’s business, but the company caught my eye when the shares dropped during this banking panic. I’ve done a lot of work over the weekend, and I don’t think that Schwab shares the same risks as the regional banks. They have a diverse set of clients who don’t have a lot of incentive to take their money elsewhere. Some portion of their deposits are in IRAs, 401(k)s and corporate retirement accounts, so it can’t be withdrawn into cash. They have seen inflows of capital in a rush to perceived safety and they have strong liquidity. Their loan portfolio doesn’t seem to be in danger because of rising rates, so I think the sell off is way overblown.
The insiders agree with me and have put their money where their mouths are, so I’m planning on following them into a position.
Now, panic is certainly not rational and predicting what the public will do is difficult if not impossible. So there is a risk that the panic continues to spread, and Schwab gets into trouble too. Just because I feel comfortable investing in Schwab doesn’t mean you should.
You should know better than to take investment advice from strangers on the internet, but just so neither of us gets into trouble, I’ll make things clear. This is just my opinion. I’ve posted my thoughts to help you research and learn, as well as to get feedback on my thoughts. This isn’t investment advice.