Description

I wonder if this is a first, this is the long SCHW pitch to pair with today’s short SCHW pitch.  This write up is not intended to count towards my two for the year, but maybe if I’m lucky VIC will determine it deserves an emergency exception in the spirit of the FDIC’s emergency exception this weekend given how different the content of this write up is than the SCHW long posted at the end of last year.   I'm just posting this to facilitate a fact based back and forth discussion of SCHW.

Mythbusters – Balance Sheet Edition

No, SCHW does not have negative $9B of TBV. 

As of today, I estimate SCHW has around positive $4B of TBV marking all securities and loans to market.

The incorrect figure of negative $9B is based on a few errors.  (1)  It subtracts the pre-tax unrealized losses on HTM securities, not the after-tax unrealized losses.  (2)  It subtracts all of the HTM losses, despite the fact that losses on the HTM portfolio that accrued before it was transferred to HTM are already included within AOCI on the balance sheet.  (3)  It ignores todays change in rates which likely reduces after-tax securities losses by ~$4B.  (4)  It ignores earnings since 12/31.

When you add $4B to $9.7B of preferred equity, there is $13.7B of Tier 1 Capital even if Schwab sold all of its securities and then repurchased the same securities, thereby marking the entire balance sheet to market.  The Tier 1 Capital requirement as of 12/31 was $15.8B. 

So if SCHW sold every security and loan on its balance sheet and marked the whole thing to market, it would need to raise $2B of preferred equity to be in compliance with the regulatory minimums assuming no loss of deposits.  Or, they could just sweep $60B of deposits into money market funds and their Tier 1 Capital requirement would drop to $13.7B and suddenly they would have no unrealized losses on the balance sheet, no capital raised, and would be above their regulatory minimum capital requirements.

So no, SCHW is not going to need to raise cheap equity for regulatory reasons (which is not to say they won’t for business reasons).  

Deposits at Schwab are Safe, and Mostly FDIC Insured Anyways

Unlike SVB or FRC, or even the SIBs, most of SCHW’s deposits (81%) are under the FDIC’s $250,000 limit.  So none of those depositors has any reason to worry.  The other 19% also has no reason to worry.  Besides this weekend’s implied backstop of all deposits, for depositors to take a haircut even in a liquidation with no support from the FDIC would require SCHW to lose 10-11% on its securities portfolio from today’s valuations.  Given the duration of 4.1 on the portfolio, intermediate term treasuries would need to increase by close to 300 basis points overnight. 

So, I highly doubt any deposits are fleeing for safety.  Who knows, they may even be a beneficiary of fear-based flight from other regional banks.  I would imagine there are many people who bank with a regional and use Schwab as their brokerage and can easily transfer cash between the two without needing to set up a new account at JP Morgan. 

Cash Sorting – Yes, it’s Happening, but I Don't Think It Matters Much at This Valuation

The above comment was regarding “fear-based” flight of deposits.  I’m certainly aware of the heightened possibility that the headlines of the last few days could be the catalyst to encourage some (possibly large portion) of the $450B of low-cost deposits on Schwab’s balance sheet to push the few buttons to move cash into money market funds or treasury ETFs.  That’s a very real possibility that needs to be considered.  But the range of possibilities is quantifiable.  

Valuation – Range of Possibilities

I’ll start with the low-end of the range.  Every dollar of deposits flees immediately (I’m going to make the simplifying assumption that the balance sheet is daily liquid), and Schwab converts into a pureplay brokerage with no bank. 

In this scenario, as described above, we can liquidate everything and there’s $4B of TBV.  So, the balance sheet is fine.  All the securities are liquid, so for practical purposes it could actually be done.  On the income statement, we’d have to replace $66B of funding for our margin lending business with 4.5% CD’s instead of low-cost deposits (since they all fled), so our Net Interest Revenue (3% spread on margin lending + securities lending revenue) would decline by $9.9B.  Money market fund fees would increase by $2.2B though.  So net revenue (after-tax) would decline by $5.9B.  Run-rate earnings counting the additional $600MM of TD synergies to be realized would be $2.6B.  I’m going to speculate that in the $11.4B of expenses last year, some of that was probably spent running the bank.  I’m going to guess they could earn at least $4.5B if they shut down the bank (cut the expense base by ~20%).  Market cap right now is $98B.  In this scenario, you’d be paying 22x earnings for a business that has grown client assets (and revenue) by 7-10% per year for decades, and earnings by more since expenses only need to grow by 3-5% per year.  Doesn't seem crazy cheap but doesn't seem expensive either.

The other end of the spectrum is we assume deposit sorting stops today (obviously I don't believe this is possible).  In that scenario, SCHW is earning $8B on a $98B market cap, NIM would be expanding over time as ~$30B of securities mature each year and roll from earning 1.8% to 4% (adding $0.5B/year to earnings), and they would continue on growing client assets 7-10% per year and expenses 3-5% per year.  You get an 8% yield, 10%+ growth excluding NIM expansion which would add 5%/yr growth for several years.  Again, I do not believe this is even remotely realistic.  I'm just framing the extremes.

I think it's helpful to frame the extremes since in my view, the extreme downside case ends with a reasonable price for a great business.  I think reality is somewhere in between, but much closer to the upside case than the downside case.  Time will tell.

p.s. – For Cuyler

I appreciate your push back, admire your ability to change your mind, and enjoy your contributions to VIC.  See above for what I think SCHW is worth.

I don’t think it was strange for the CFO to not mention the incremental 1q23 FHLB and repo borrowings since it’s (a) disclosed in the 10-K, (b) does not appear to have been related to mass outflows given they stated deposit outflows in February were less than January and March has been consistent with February, and (c) it was likely in anticipation of seasonal tax outflows and the recent sharp increase in short-term rates.

And I agree, it's unfortunate that they didn't keep duration shorter but all I can do is value the business as of today.

Catalyst

Deposit outflows moderating and/or panic subsiding.