Why Schwab Got Hit in the Panic Over Regional Banks

Why did Charles Schwab, the nation’s largest publicly traded brokerage company, a financial giant with $7 trillion in assets and 35 million accounts, get swept up in the recent banking turbulence?

It’s a question that left many scratching their heads in recent weeks, as the sudden collapses of Silicon Valley Bank and Signature Bank also crushed Schwab’s stock. Since March 8, when Silicon Valley Bank startled investors by saying it needed to raise cash, shares of Schwab have plummeted 31 percent.

The reason is twofold. Although Schwab is best known for its core business of offering trading and investing accounts, its huge operation includes what would rank as the nation’s 10th-largest bank, which held $367 billion in deposits at the end of last year. But the bank also held roughly $28 billion in bond losses on paper at the end of 2022, an eerie parallel to Silicon Valley Bank, which held similar securities but had to sell them at a loss when depositors demanded their money.

“Investors often shoot first (sell) and ask questions later,” Stephen Biggar, director of financial services at Argus Research in New York, said in an email. “The initial Schwab concern had to do with the amount of deposits invested during a low interest rate period and thus held at a loss currently. But Schwab does not have the other areas that were SVB’s undoing.”

The bond losses are a product of rising interest rates: Some in the financial services industry didn’t anticipate just how quickly the Federal Reserve would raise its key rate as it tried to contain inflation. Many banks hold long-dated bonds with low interest rates, which have become increasingly unattractive as the Fed raises rates and new bonds with higher interest rates became available. But as long as the banks pledged to hold on to those older bonds until they matured, for accounting purposes, the lower values showed up as so-called unrealized losses on their balance sheets.

The real problems arise, as they did with SVB, when those investments must be sold to meet withdrawal requests from depositors. Schwab executives recently took pains to assure investors that was something it wouldn’t need to do.

In a recent note to customers, employees and investors, Charles Schwab, the brokerage’s founder and a co-chairman, and Walt Bettinger, a co-chairman and its chief executive, went as far as saying there was “a near-zero chance” that it would have to resort to selling those investments.

Still, the unrealized losses — largely in mortgage-backed securities and Treasuries — were enough to spook investors. Schwab’s stock closed on Friday at $52.38, down from $76.20 on March 8, two days before the federal government shuttered SVB. It’s down nearly 44 percent, from $93.16, on March 29 of last year.

Silicon Valley, which was the nation’s 16th-largest bank, failed after depositors pulled their cash because they feared they might lose it all if they didn’t. The majority of SVB’s customers — mainly start-up founders and venture capitalists — held large sums of their money at the bank, exceeding the Federal Deposit Insurance Corporation’s insurance limit of $250,000.

In contrast, Schwab’s deposit base is made up of retail customers, and 80 percent of that money falls beneath the F.D.I.C. ceiling, easing any fears that their deposits could disappear.

“Schwab shouldn’t ever have to change those unrealized losses into realized losses by selling the securities, because it has so much access to cash,” said Michael Wong, director of equity research, financial services, at Morningstar.

Mr. Wong said the company had access to the Federal Reserve’s new emergency lending program, which can provide it with more than $200 billion in cash to deal with potential deposit withdrawals by clients. It also had about $40 billion in cash on its balance sheet at the end of 2022, Mr. Wong added, and more than $50 billion of cash is expected to come in this year, according to his calculations, as well as other sources of liquidity.

But while Schwab may have access to plenty of capital, he said, the company’s earnings will be lower than he previously thought because its cost of borrowing is increasing as interest rates rise: The company usually turns to its deposit base for funds, but that has been steadily shrinking as customers move their money into more lucrative accounts with higher yields.

As a result, more stock watchers have become increasingly pessimistic in their projections on Schwab’s outlook. Since the start of the year, Wall Street analysts have been steadily cutting their first-quarter earnings estimates: The consensus estimate has been cut to 94 cents a share from $1.09 in January, according to IBES data from Refinitiv, a financial markets data provider.

Like many financial services firms, the brokerage giant has had to adapt quickly to higher interest rates. More than half of Schwab’s overall revenue last year came from so-called net interest revenue: Most of that is generated from its customers’ uninvested cash.

Schwab will pay customers interest of, say, 0.45 percent on their assets and then invest the money at higher rates. The bank then pockets the difference. But as customers shift those deposits into more higher-yielding accounts at Schwab or elsewhere, Schwab’s bottom line is likely to suffer.

Schwab’s bank, which it added in 2003 to provide customers with more products and services like basic checking and certificates of deposit, operates a bit differently from most traditional banks. Lending is only a small piece of its business. Instead, it invests most of its customer deposits into safe government securities.

The company, which pioneered discount investing more than 40 years ago, has continued to push the boundaries of retail investing. In the fall of 2019, it eliminated all trading fees on stocks and exchange-traded funds. Months later, in another bold move, it acquired a top rival, TD Ameritrade, catapulting it past Fidelity to become the largest brokerage company, according to Cerulli.

The rest of Schwab’s revenue is generated from trading, asset management and other fees drawn from its brokerage business. Given all the unrest in financial markets, investors will be closely scrutinizing Schwab’s and other financial institutions’ first-quarter earnings reports — coming out in April — for any worrisome signs.

“Just like a good portion of the financial sector,” Mr. Wong of Morningstar said, “there’s plenty of uncertainty.”

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