This Is What's Going On With Schwab (NYSE:SCHW) (2024)

Overview

On the surface, Charles Schwab (NYSE:SCHW) bears very little resemblance to the startup and crypto-funding banks like SVB Financial Group (SIVB), Silvergate (SI), and Signature Bank (OTCPK:SBNY). However, over the last several days the stock has taken a beating right alongside these lesser-known names, falling by over 30%.

The big question on most investor's minds is a single word: why?

Why has this household name stock, which most know as an investment platform but which also operates a sizable bank, been caught up in this mess? And should investors be concerned?

Getting Ratio'd

Before we dive into why Schwab is getting hit, let's briefly cover one of the main ratios used by regulators to determine a bank's financial health, the Tier 1 Capital Ratio (we'll call it the TCR). The TCR takes the bank's equity capital and reserves against its risk-weighted assets. The Charles Schwab Bank is required--per the company's 10K--to have a TCR of at least 5%, with a company-internal target of 6.25%. At the end of 2021, Charles Schwab Bank reported a TCR of 7.1%, and 7.3% in 2022.

So, moving in a positive direction, right?

Well, this is where accounting comes into play.

Securities in a bank's books can be held in various ways, and those ways typically each have a different method of accounting. If a bank holds a bond on its books as held for sale (or available for sale), then these instruments are required to be valued at essentially fair-market value. Conversely, bonds classified as held to maturity are immune from this accounting treatment because the institution is expected to hold the bonds for their life-that is, they aren't shopping these around and expect to get their money back, so why post unrealized gains or losses on something that you aren't looking to get rid of anyway?

The reason all of this matters is because Accumulated Other Comprehensive Income (known as AOCI, this figure incorporates gains or losses not reflected in earnings like unrealize gains and losses) are excluded from the bank's common equity Tier 1 capital. This may not matter so much in a non-volatile interest rate environment, but the amount can be quite sizable when interest rates are moving.

For example, at the end of 2020 Schwab had a positive $5.3 billion AOCI. At the end of 2021, it was a negative $1.1 billion. In 2022, the number stood at negative $22.2 billion.

Treatment of AOCI in calculating capital ratios has been tweaked over the years by Schwab, but in its most recent 10K the company included a footnote to its ratio calculations that "changes in market interest rates can result in unrealized gains or losses on AFS securities, which are included in AOCI. As a Category III banking organization, [Charles Schwab Corporation] has elected to exclude AOCI from regulatory capital."

Normally we would understand a bit of mismatch-a slight gain or loss on a book of long-duration holdings... but the unrealized loss of $22 billion seems to us like a much, well, bigger deal.

The company also took efforts to stem the bleeding from unrealized losses by making large re-classifications of securities from held for sale to held to maturity. On page 31 of the 10K, the company states that "In January and November 2022, the Company transferred $108.8 billion and $79.8 billion, respectively, of its investment securities from the [Assets For Sale] category to... held to maturity." To find the unrealized losses on those two transfers, you have to keep reading until page 58, where it states that these two transfers resulted in "net unrealized losses at the time of transfer of $2.4 billion and $15.8 billion, respectively."

By making this switch, for the reasons stated above, Schwab essentially loses the requirement to report unrealized losses and can mark the assets at cost.

Of course, these securities don't just stay in a bubble because they've been reclassified. Schwab discloses on page 108 of its 10K that the carrying value of its held to maturity securities (which are held in U.S. agency mortgage-backed securities) was $173 billion, with an assessed fair value of $158 billion.

While taking a $15 billion haircut never sounds fun, what's perhaps most shocking is the rate at which Schwab is earning interest on these securities. Page F-2 of the 10K shows that for year 2022, Schwab earned an average of only 1.5% on a calculated average balance of $112 billion in held to maturity securities, earning only $1.6 billion in interest.

Bank deposits, meanwhile, were down year over year. In 2021 Schwab carried $443 billion in deposit liabilities, and at the end of 2022 reported $366 billion.

Given that the company's primary source of cash is client deposits, all of this presents an obvious problem. Deposits are decelerating as interest rates rise and decrease the value of the company's held securities.

Perhaps the best explanation is done by Schwab itself. The company added an important new paragraph into its risk disclosures this year (emphasis added):

When short-term interest rates rise rapidly, as they did in 2022, the pace at which clients move certain cash balances out of our sweep features and into higher yielding alternatives generally increases. When these outflows outpace excess cash on hand generated by maturities and paydowns on our investment and loan portfolios, as they recently have, our banking subsidiaries may use temporary supplemental funding, such as advances under Federal Home Loan Bank [FHLB] secured credit facilities, borrowings under repurchase agreements with external financial institutions, and issuances of brokered certificates of deposit, which have higher costs. In addition, to access new FHLB advances or roll over existing advances, our banking subsidiaries must maintain positive tangible capital, as defined by the Federal Housing Finance Agency. Larger unrealized losses on our available for sale (AFS) portfolio due to higher market interest rates could negatively impact our tangible capital.

When It Pays To Be Low Cost

As noted above, all of these issues were disclosed near the end of February when the company filed its 10K. It doesn't seem, however, that the reality of what was happening behind the scenes mattered all that much to investors until things began to look shaky at Silicon Valley Bank.

However, as you might expect, the bond market detected this weakness long before the equity did--Schwab's A-rated 2028 bonds traded at $90 on the day of the earnings call and immediately began trending downward. As of this writing the bonds last traded at $84.

So all of this analysis begs the question -what could happen now?

While investors may be pulling their hair out over the fact that Schwab is earning a fraction of the current risk-free rate on its held to maturity debt, it remains the case that its operating expenses remain well below its current net interest income.

In 2022 Schwab earned $12.2 billion on its interest-bearing assets, while incurring costs of only $1.5 billion on its liabilities. This is something of a calling-card for Schwab as management prides itself on running a low-cost operation.

Of course, all the low-cost operations in the world will seem pretty steep if investors lose confidence in the business.

The Bottom Line

There doesn't seem to be much in Schwab's numbers to suggest that the firm is in intrinsic trouble--although the somewhat cryptic references to advances from the FHLB in its risk disclosures don't exactly inspire confidence--but the fact remains that the current banking crisis has exposed a weakness in the business that must be sorted out more fully before investors can breathe easy.

For now, we're staying away from Schwab for the following reasons:

1. Management has clearly been caught flat-footed by rising interest rates, as evidenced by a 1.5% return on securities held to maturity (the majority of which have a more than 10-year duration).
2. Deposits are decelerating as clients search for yield outside of savings accounts.
3. It's very difficult to determine exactly how close to the edge the company may be (if at all) given the various ratios and 3-D chess-type scenarios that involve interest rates, the actions of the fed, and the behavior of depositors.

For those reasons we believe investors should exercise extreme caution before diving into Schwab stock.

Looking for value, or lack thereof, throughout the market. Long by nature, short by necessity, generally contrarian.