Why is Charles Schwab, the largest publicly traded brokerage firm in the United States and a financial giant with $7 trillion in assets and 35 million accounts, involved in the recent banking turmoil?
That question has puzzled many in recent weeks, as the sudden collapse of Silicon Valley Bank and Signature Bank also crushed Charles Schwab’s stock. Since March 8, when Silicon Valley Bank shocked investors by announcing it needed to raise cash, Credit Suisse shares have plunged 31 percent.
The reason is twofold. While Charles Schwab is known for its core business of offering trading and investment accounts, its massive operations include what will become the nation’s 10th-largest bank, which held $367 billion in deposits at the end of last year. But the bank also holds about $28 billion in losses on its bond book by the end of 2022, a striking similarity to Silicon Valley Bank, which held similar securities but had to sell them at a loss when depositors demanded deposits.
“Investors usually get out (sell) first and ask questions later,” Stephen Biggar, head of financial services at Argus Research in New York, said in an e-mail. “Schwab’s initial concerns were related to the number of deposits invested during the low interest rate period and therefore currently at a loss. But there are other areas where Schwab is not SVB-damaged.”
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Bond losses are a product of rising interest rates: Some in the financial services industry did not anticipate how quickly the Federal Reserve would raise its key interest rate as it tried to curb inflation. Many banks hold long-term bonds with low interest rates, which are becoming less attractive as the Fed raises rates and new bonds with higher rates become available. But as long as banks are committed to holding these older bonds until maturity, the lower values show up on the balance sheet as so-called unrealized losses for accounting purposes.
The real problem arose, as they did with SVBs, when these investments had to be sold to meet depositors’ withdrawal requests. Charles Schwab executives recently took great pains to assure investors that this was something they did not need to do.
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“Nearly Zero Chance”
In a recent report to clients, employees and investors, the brokerage’s founder and co-chairman, Carlson Capital, and co-chairman and CEO, Walter Bettinger, even said there was a “near-zero chance” it would have to resort to selling the investments.
Still, the unrealized losses – mainly in mortgage-backed securities and U.S. Treasuries – were enough to scare investors. Charles 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 was down nearly 44 percent from $93.16 on March 29 last year.
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A man crosses the street in front of a Schwab store in San Francisco. The blue Charles Schwab letters are on the wall next to the front door of the building.
Unlike many Silicon Valley banks, where customers hold large sums of money, Charles Schwab’s deposit base consists of retail customers, most of whom have less than $250,000 in their accounts. Credit… …Aaron Wojack for The New York Times
Silicon Valley, the nation’s 16th-largest bank, collapsed after depositors withdrew cash because they feared they might lose it all if they didn’t. Most of SVB’s customers – mainly startup founders and venture capitalists – held Most of SVB’s customers – mainly startup founders and venture capitalists – hold large amounts of money in banks that exceed the FDIC’s $250,000 insurance limit.
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By contrast, Charles Schwab’s deposit base consists of retail customers, 80 percent of whom are under the FDIC cap, easing concerns that their deposits could disappear.
“Schwab shouldn’t be turning these unrealized losses into realized losses by selling securities because it has plenty of cash sources,” said Michael Wong, head of equity research at Morningstar Financial Services.
Mr. Wong said the company could use the Federal Reserve’s new emergency lending program, which could provide it with more than $200 billion in cash for deposits that customers might withdraw. Wong added that it has about $40 billion in cash left on its balance sheet by the end of 2022 and, by his calculations, expects to have more than $50 billion this year as well as other sources of liquidity.
Concerns about earnings
But while Schwab may have access to a lot of money, he said, the company’s earnings will be lower than he previously expected because its borrowing costs have increased as interest rates have risen: The company has typically turned to its deposit base for funding, but that has been steadily shrinking as customers move their money into more profitable accounts with higher yields.
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As a result, more equity watchers have become increasingly pessimistic in their predictions about the prospects for Carlson Financial. Since the start of the year, Wall Street analysts have been steadily lowering their first-quarter earnings estimates: The general market expectation has been cut to 94 cents a share from $1.09 in January, according to IBES data from Refinitiv, a provider of financial market data.
Like many financial services companies, the brokerage giant has had to adapt quickly to higher interest rates. More than half of Charles Schwab’s total revenue last year came from so-called net interest income: most of it came from its clients’ uninvested cash.
Charles Schwab would pay clients, say, 0.45 percent interest on their assets, and then invest the money at a higher rate. The bank then pocketed the difference. But as customers move these deposits to higher-yielding accounts at Credit Suisse or elsewhere, Credit Suisse’s profits may suffer.
Schwab’s bank, which joined in 2003 to offer customers more products and services, such as basic checking and certificates of deposit, operates slightly differently than most traditional banks. Lending is only a small part of its business. Instead, it invests most of its customers’ deposits in safe government securities.
The company, which pioneered discount investing more than 40 years ago, has been pushing the boundaries of retail investing. in the fall of 2019, it eliminated all transaction fees on stocks and exchange-traded funds. A few months later, it made another bold move by acquiring its biggest competitor, TD Ameritrade, making it the largest brokerage firm ahead of Fidelity, according to Cerulli.
