PACWP - Silicon Valley Bank Fallout: Opportunity In Schwab?

2023-03-14 06:00:00 ET

Summary

• Silicon Valley Bank's failure triggered runs on the bank even with relatively well-run financial institutions.
• Business model and regulatory changes likely coming for regional banks.
• The subsequent market panic created opportunities in companies with little to no exposure to the same issues that felled SVB.

SVB Financial Fallout:

The problem with financial institutions blowing up is that it almost never happens in a vacuum. Failure of one financial institution can easily raise concerns in others. Lehman's failure in 2008 was perhaps the most extreme example of this dynamic. Lehman was a different animal than SVB Financial ( SIVB ) and 2008 was a different environment than now, but there are parallels between then and now.

The main difference between the chaos triggered by the Lehman collapse and Silicon Valley Bank is a derivative book. Lehman, as a large cog in the Wall Street machine, was a major derivative counterparty. At that time, failure along any part of a derivative counterparty chain created liability mismatches for virtually every financial player. Silicon Valley Bank is a major player in the Silicon Valley/early stage tech ecosystem, but its failure doesn't really directly impact other financial institutions.

The indirect impacts of the failure, however, are proving to be quite devastating for regional banks and some other financial institutions that people believe resemble SIVB. Simply put, the nearly 90% of SIVB's deposits that were too large to qualify for FDIC were feared lost going into the weekend. That fear led to depositor panics, which led to runs on the bank at formerly well-regarded banks such as First Republic ( FRC ), PacWest ( PACW ), and SBNY.

The Federal response guaranteeing the depositors at SIVB and SBNY has generally failed to calm investors. At the time of this writing, FRC, PACW and other regional banks are down about 65% since last Wednesday. My sense is that these moves are massive overreactions, and the stocks of many regional banks are buys here. That said, a huge amount of psychological damage has been done in the blink of an eye. Deposit bases could be impaired for a while and regionals will almost certainly face stiffer regulations, likely the same as money center banks such as JPMorgan ( JPM ). That combination will almost certainly negatively impact earnings.

One company that I think has been unfairly tarnished from SIVB's failure is Charles Schwab ( SCHW ). At the time of this writing, SCHW is down about 33% from last Wednesday (~from $76 to $51). The fear is that SCHW has large losses in its hold-to-maturity portfolio that could wipe out book value if they were forced to sell. I think this fear is misplaced for several reasons.

I don't think people realize what a giant SCHW is. Total client assets were $7.38 trillion across 34 million accounts, many of which are retirement accounts, as of the end of February. Its clients hold almost $300 billion of money market funds. It has a bank with accounts holding over $120 billion of deposits. 80% of these accounts fall within the FDIC's $250k limit.

Along with Fidelity, SCHW is also one of the largest custodians for RIA's (registered investment advisors). If you have an independent advisor, meaning one that doesn't work at Morgan Stanley ( MS ), UBS ( UBS ), Merrill Lynch ( BAC ) etc., chances are that advisor keeps client assets at SCHW or Fidelity.

In short, SCHW is an essential cog in the financial system. It takes that role seriously. While SCHW has losses in its HTM portfolio, the liquidity of that paper is likely better from the rally in treasuries and the Fed's actions over the weekend. The company also put out a release today disclosing robust liquidity including an:

estimated $100 billion of cash flow from cash on hand, portfolio-related cash flows, and net new assets we anticipate realizing over the next twelve months. We believe we have upwards of $8 billion in potential retail CD issuances per month, plus over $300 billion of incremental capacity with the Federal Home Loan Bank ((FHLB)) and other short-term facilities - including the recently announced Bank Term Funding Program (BTFP)"

I hesitate to say "too big to fail", since that statement is fraught with risk, but if SCHW fails, it would be utter chaos. I also strain to see how SCHW could possibly be at serious risk of failure. There's just so much liquidity and very few loans against deposits.

If people are selling down SCHW because they think earnings will decline or they're applying a lower multiple to earnings, that's one thing. On that note, SCHW is expected to earn about $4.25/share this year so it's at a 12x multiple, well below the 5 and 10 year average multiples of 21x and 25x respectively. To the extent the stock has sold off because of insolvency fear, I think that fear is misplaced, and the stock is a buy here, or at least calls are worth exploring. You can hedge the disaster that would be a SCHW failure by buying out of the money SPY puts or KRE puts for more direct high vol financial downside.

Risks:

The environment created by bank runs is volatile and unpredictable. I do not think we're through the worst this market will see. One must tread carefully. Specifically with regard to SCHW, there is always black swan risk, and SCHW could fail because of something that is not currently apparent. SCHW has also been volatile and likely will continue to be so. For those looking to limit their exposure, the payouts for April out-of-the-money call spreads are pretty interesting.

Conclusion:

In volatile times, there can be tremendous opportunities. When Lehman blew up, great franchises were available at incredible discounts. Moreover, to the extent one wants to invest in risk assets, size is usually a safe haven. It's hard to find a player much bigger in its industry than SCHW. By all appearances, the company has adequate liquidity, and I believe that the chaos its failure would cause among retail investors and their advisors would be so terrible the Feds would do almost anything to save SCHW. That said, there are no guarantees, so give any investment in SCHW time to work and consider any position with a broader market hedge.

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