Update: Charles Schwab (SCHW); Sagent Presentation
April 3, 2023 | Premium Service | Over the past two weeks, a number of readers of The Institutional Risk Analyst have asked about Charles Schwab (SCHW). The name is down 36% YTD, but is still trading at 3.6x book value. As a courtesy to all of the readers of The IRA, we are posting this profile for general readership. If you send questions to email@example.com, we’ll try to answer on Twitter @rcwhalen.com.
In addition, at the bottom of this comment, subscribers to our Premium Service may download our presentation last week to the advisory board of Sagent, an exciting new entrant into the world of mortgage servicing technology. Sagent combines the tested loan servicing platform developed by Mr. Cooper (COOP) and financing from Warburg Pincus and Fiserve (FISV).
Like Silicon Valley Bank (SVB), Bank of America (BAC) and many other institutions, SCHW has a large portion of its assets invested in “AAA” rated mortgage backed securities (MBS). Unlike SVB and a number of other banks, however, SCHW is not insolvent. Moreover, the bank is so low risk in terms of credit exposures and has such a liquid balance sheet, that we view SCHW as having a low likelihood of failure. Why?
First and foremost comes liquidity. SCHW is the tenth largest depository in the US as of Q4 2022 with $550 billion in assets or roughly 2.5x the size of SVB. The deposit base of SCHW is a function of advisor balances and market activity. Thus earlier in the year, SCHW was number six in the US in terms of assets. SCHW was actually larger than U.S. Bancorp (USB), which itself is now close to $700 billion in size. Most major banks grew larger during quantitative easing or “QE” and now many of these banks will shrink in terms of assets and also earnings.
Second is credit risk. Net loans and leases are less than 20% of total assets at SCHW, with the remainder held in securities. Since the bank takes little credit risk and has a default rate near or below zero, balance sheet size is really a matter of management preference and managing duration. With the US Treasury paying 4% for 90 day bills, it is natural that non-interest bearing deposit balances are moving to time deposits and Treasuries. Like most large banks. one-third of SCHW's earning assets reprice every year.
Third is the nature of the business model. The bank unit of SCHW receives captive business flows from the advisors that work on the SCHW platform. The bank is essentially a convenience for the advisors and their clients, growing or shrinking with interest rates. Between Q3 and Q4 2022, SCHW shed 18% of assets, but this declining trend in asset size goes back more than a year.
As a result of rising interest rates, SCHW reported negative accumulated other comprehensive (AOCI) at the end of 2022 of -$20 billion. Unlike SVB which was visibly insolvent in Q3 of 2022, SCHW had positive net worth at year-end 2022 net of AOCI to the tune of $40 billion in Tier 1 capital.
Remember, the negative AOCI position for SCHW and most other US banks will be lower when Q1 2023 earning are reported in two weeks. Your surrogate for this key relationship is the 10-year Treasury note. In Q3 2022, the 10-year Treasury was over 4%, but today it is closer to 3.5%. That's a hint.
Going back five years, net-interest income and non-interest fee income have been relatively equal parts of SCHW earnings, but at the end of 2022 the bank unit accounted for two-thirds of consolidated earnings due to balance sheet growth. The growth in interest income at SCHW is largely due to the increase in the size of the bank, which has far more liquidity than it can lend.
The parent company realized $10.1 billion in income in 2022 and received another $10 billion in interest payments from subsidiaries. The breakdown in the sources of income to the parent holdco, the company we all know as SCHW, is found in the Form Y-9.
The chart above illustrates how QE from the Fed first inflated and now will deflate SCHW and many other banks. The bank has grown in recent years to 65% of consolidated income, but reversing this growth is easily done and, indeed, is likely in the current interest rate environment. Notice that noncore funding is a relatively small part of the overall SCHW business.
Since the bank’s risk weighted assets for measuring regulatory capital for Basel are only $150 billion, SCHW could essentially write down the MBS to the current market tomorrow and shrink the bank down to one quarter of the current size. As CEO Walter Bettinger told the media last week, he can liquidate the bank without selling a single security. Note to hedge funds: That's a hint.
As we’ve noted previously, SCHW has the lowest cost of funds vs Peer Group 1, in large part because they don’t need the cash. Interest expense as a percentage of total assets was just 0.24% vs 0.5% for Peer Group 1 at the end of 2022. The cost of funds for Peer Group 1 may double in Q1 2023, but SCHB is unlikely to care. If clients migrate from deposits to T-bills, SCHW will simply shrink the bank.
The sharp difference between SVB and SCHW illustrates why qualitative factors must be considered when assessing a bank’s business model. Simply looking at the top level data, you might think that banks of like asset size are comparable. But, in fact, institutions such as USB or Truist (TRU) or PNC Financial (PNC) that are close in size to SCHW have little else in common. In the data driven (i.e. numeric) world of trading, immediacy often trumps understanding.
When it comes to SCHW, Raymond James Financial (RJF), Morgan Stanley (MS), UBS AG (UBS) and other “asset gatherers,” the broker-dealer is most of the income, capital and liquidity of the group. Moreover, we should be mindful of the fact that the bank units access business because of the broker-dealer and the advisory business.
Source: Google Finance
At year-end 2022, 35% of the SCHW group’s income came from non-interest sources or twice the average for large banks, but shrinking the bank down to $300 billion or less in assets would restore balance to the business model. We suspect that this is precisely what is going to happen over the next year or so, not only for SCHW but for other advisory businesses as well.
Bottom line: We look for all large US banks to shrink in terms of both baance sheet assets and earnings in the next 24 months. The $100 billion plus in monthly runoff from the Fed's balance sheet will slowly reduce liquidity in the system, pushing down balance sheet assets and also asset returns.
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