2023-03-14 07:00:00 ET
Summary
- Charles Schwab shares have plummeted amid the current financial industry panic.
- I believe Schwab's balance sheet is sufficient to ensure the firm's ongoing operations and that clients are at minimal risk.
- That said, I'm not convinced the stock is cheap enough to make it a compelling buy just yet.
- I'd suggest that TD Bank and Interactive Brokers are more appealing options that have catalysts based on the Schwab situation.
Leading discount broker Charles Schwab ( SCHW ) has become a focal point of the current panic in financial stocks. Shares had been trading around $75, give or take a few bucks, since late last year. Now, however, it has suddenly come unglued, with shares diving to just $52 as of Monday's close:
This is a particularly surprising outcome since Charles Schwab was long discussed as one of the single most obvious ways to benefit from higher interest rates. It was a very common thesis among hedge funds and smart money to own SCHW stock to profit from the Fed's current rate hike cycle.
And yet, it would appear that this is not what has ultimately happened. If anything, Schwab now finds itself in a state of crisis primarily due to the abrupt changes in interest rates and the secondary consequences therein. So, what's gone wrong, and how bad is it?
Schwab's Two Core Issues
Charles Schwab has two primary concerns right now. The first of these are unrealized losses on its securities portfolio. This is the same sort of problem that we've seen at a large number of regional banks lately.
It's important to note that Charles Schwab, while being a brokerage firm, has a banking license and has a significant number of similar factors underlying its balance sheet management as that of a regional bank. Schwab, like many others, put money into securities at low interest rates and is now paying the price as the value of those held securities have dropped sharply in value.
As Schwab's core competency is brokerage services, not underwriting loans of its own, it's logical that Schwab would put capital into traded fixed income securities. Prices on these will naturally fluctuate, sometimes giving Schwab unrealized gains and other times leading to losses. Normally, this shouldn't matter as Schwab shouldn't be forced to sell these securities during a down period. But right now, all bets are off given what's happened to other banks.
This comes to Schwab's other issue, which is what some people have called " cash sorting ". In short, clients hold a lot of cash in their Schwab brokerage accounts. Schwab typically pays very low interest rates on this cash while being able to invest it in fixed income securities at higher rates.
As brokerages have moved toward low- or no-commission models, it has become ever-more-important for Schwab and other brokerages to make more money on fees and net interest rate margin. Thus, this use of client cash is key to making profitability numbers pencil out.
Now, however, many clients are taking cash out of their Schwab accounts and putting it into other alternatives such as CDs, treasury bills, money market funds, and so on. Indeed, Schwab's bank deposits fell from $444 billion to $375 billion between 2021 and 2022 as clients took advantage of higher interest rates to move cash to more fruitful destinations.
Charles Schwab's management had previously signaled that it felt that cash sorting was nearing the end for this cycle. Once the Fed finishes hiking interest rates, most clients typically stop moving cash out of their default brokerage position into higher-yielding alternatives.
But, this past week's events cast that into doubt. Now, people are reconsidering how much they want to hold in uninsured deposits at brokers such as Schwab. There is the risk of Schwab running into trouble, of course, but also the fact that many people are realizing that in a world of 5% short-term money rates, it makes little sense to hold cash in a low-yielding brokerage account. A bunch of idle money is getting redeployed this week, and that will hurt Schwab's profitability going forward.
Is Schwab at material risk of failure? I don't believe so. The bank has a reported $69 billion of lending capacity at the Federal Home Loan Bank ((FHLB)). That's in addition to the $40 billion of cash and billions more of short-term money-good government securities that Schwab owns. That is an awful lot of firepower with which to defray a near-term deposit run on Schwab. I'd note that the FHLB line of credit alone is equal to virtually all of the uninsured deposits at Schwab. That's a key difference; unlike the banks that have failed, the majority of Schwab's depositors are fully insured and thus have far less reason to pull funds in a panic.
And, unlike in a traditional bank, there is somewhat less likelihood that depositors would run away from Schwab en masse as cash is needed to trade stocks and other financial instruments, after all. Remember that there are far fewer competing brokerages out there as compared to banks, especially due to all the recent consolidation in the industry.
That said, having tens of billions of dollars more leave Schwab bank in coming days and weeks would meaningfully ding Schwab's profitability.
On the other hand, I'd also note that Schwab earned $7 billion last year, and it can offset a meaningful portion of its unrealized losses in its loan securities book simply by using profits for the next few quarters to match loans sold at a loss if absolutely necessary.
To put it simply, Schwab's loan book is currently not in a desirable position, and it will cost the bank for quite a while in terms of foregone interest income and operational flexibility in coming quarters.
I wouldn't be shocked if Schwab raised equity or otherwise took measures to strengthen its balance sheet. In the long-run, retaining client trust is most important and stockholders might have to take a short-term hit for the greater good, which in this case, is the balance sheet. As such, I don't see SCHW stock as a slam dunk buy here by any means. But I also don't see much of any possibility of it collapsing to zero a la SVB Financial either.
Charles Schwab's Pain May Be Interactive's Gain
A lot of investors have thought about pulling some of their funds out of Charles Schwab given the recent uncertainty. This leads to the question, if Schwab is losing market share, who would be the beneficiary?
Interactive Brokers ( IBKR ) stands out as the most obvious winner in a resulting brokerage industry reshuffling. Interactive is known for its professional trader-oriented offering. It serves many small hedge funds and registered investment advisors. However, it is also popular with many sophisticated retail traders due to its low margin loan rates, wide variety of international markets, and its broad offering of stocks available for short sale at reasonable borrow rates.
In any case, Interactive Brokers may pick up a lot more retail customers in the coming days and weeks. That's because the firm's founder and chairman, Thomas Peterffy, has long insisted that the company take virtually no balance sheet risk.
Interactive has no long-term debt and enjoys an A- credit rating from S&P. It has $11.6 billion in equity capital, whereas its regulatory requirement is just $3.9 billion. That's quite the cushion! Interactive's employees and affiliates also own 75% of the company, meaning management has far more skin in the game and incentives to keep the firm secure as opposed to brokerages where management has less ownership. Finally, the company has no exotic investments; no CDOs, no MBS, no CDS. Instead, Interactive keeps its balance sheet in U.S. T-bills, which are among the world's safest and least volatile assets.
All this to say that anyone looking for a safer brokerage is likely to consider Interactive Brokers in coming days and weeks.
Interactive shares have held up far better than Schwab, not surprisingly, but are still off 10% over the past month:
Arguably, Interactive shouldn't be down at all, and could even potentially rally if it gains meaningful market share from weaker rivals.
If You Do Want To Own SCHW, Consider TD
There's another interesting wrinkle here to consider. Canada's Toronto-Dominion Bank ( TD ) received a big block of Schwab shares as part of compensation around the merger with TD Ameritrade.
As of Dec. 2022, TD owns 12.6% of the outstanding stock in Charles Schwab, or nearly 226 million shares:
At a stock price of $53 for Schwab, that works out to a $12 billion holding for TD. Not chump change. And if Schwab's stock returned to $80, where it was before the crisis, that stake would appreciate to roughly $18 billion, generating a substantial increase in value for TD.
While TD stock hasn't collapsed this week, shares have fallen sharply as well:
Over the past month, TD stock is off 15% while Charles Schwab is down 34%. TD will participate in any meaningful recovery in Schwab's shares. And, in the event Schwab did need help or further equity or something, there's a decent chance TD would have an advantaged position in participating in such an offering.
TD, with its broader business lines, assets, and geographic diversification, shouldn't have nearly the same sort of downside risk as Schwab if the current mess continues to worsen, either.
Charles Schwab Bottom Line
There are two separate takeaways here. As far as the brokerage goes, I would be exceptionally surprised if there is any material risk to clients of the firm at this time. Charles Schwab still has a ton of capital, and it is a systemically important institution. It would also be highly valuable to TD or another strategic buyer. The odds of Schwab customers seeing any interruptions to their normal business operations, in my opinion, are exceptionally low.
As for Charles Schwab stock, if I had to take a position, I'd rather be a buyer than a seller. That said, it's a highly complicated situation with a wide range out of outcomes. As such, I'm at a "hold" rating on SCHW stock for the time being.
For people that do want to take advantage of the current panic in the brokerage industry, I'd strongly consider positions in either TD or Interactive Brokers as an alternative. Both of those have also fallen sharply in recent days and should offer investors more safety while still retaining attractive upside if and when things recover. Interactive Brokers, in particular, could be quite the set-up here if it peels off a meaningful chunk of brokerage assets from other firms.
For further details see:
Charles Schwab Should Be Safe, But That Doesn't Make The Stock A Buy Yet