Description

Obviously the stock has started to react at the open today to the below thesis, after we already completed our write-up. But still posting to share with those that are curious about what’s unfolding:

Concerning: Charles Scwab has similarities to Silicon Valley Bank

As people are focusing on which regional banks are potentially next to go the way of Silicon Valley Bank, we are concerned many are missing the weakest of the large financial institutions: Charles Schwab.

Currently, with its assets marked to market value, we think the fair value Charles Schwab’s tangible equity is negative. The company’s aggressive accounting over the years has given it similar dynamics to Silicon Valley Bank.

The Silicon Valley Bank Case Study

Silicon Valley Bank’s failure provides insight into SCHW’s current woes. Between 2016 and Q1 2022, Silicon Valley Bank grew its deposit base from $40bn to $200bn. Part of these deposits (liabilities) are typically invested in treasury securities and agency-backed mortgages (assets) in case they need to be liquidated when customers choose to make withdrawals from their checking or savings accounts. 

These assets are sensitive to interest rate movements: longer duration securities decline in value when interest rates rise, and shorter duration securities are relatively less sensitive. Silicon Valley Bank held 95% of these securities in >10 year long-duration maturities, which have among the highest sensitivities to rising rates.  

The accounting for these securities depends on a rather arbitrary decision by management teams to classify them as either “available-for-sale” (AFS) or “held-to-maturity” (HTM) securities. AFS securities are reported on the balance sheet at fair market value, the price one would receive if the securities were sold on the open market at today’s prevailing price. Meanwhile, HTM securities are reported on the balance sheet at their original cost basis. These classifications have important implications on the calculation of a financial institution’s true equity value:      

With interest rates rising in 2022 (the 10-year treasury moved from 1.5% to 4%), the fair market value of SVB’s securities started to decline. In fact, as early as Q3 2022, the fair market value of SVB’s tangible common equity was already negative.   

At the same time, clients were withdrawing their deposits from $200bn down to $173bn, which continued happening in Q1 2023. At any point, a run on the bank would cause SVB to be a forced seller of all its securities at market value (an effective margin call) to meet its deposit withdrawals. Last week this happened, when nearly $44bn of withdrawal requests were made in 1 day when SVB customers panicked and asked for their money back. 

Application to Charles Schwab

Charles Schwab is arguably in a similar situation. While many are currently distracted by the banks who had the most tech and start-up exposure, like PacWest and First Republic, a similar situation has risk of occuring at this much larger financial institution. Similar to SVB, SCHW has significant exposure to the more interest rate sensitive, longer duration securities. Most recently, 72% of SCHW’s securities are in >10 year maturities and 97% cumulatively are in >5 year maturities.

Conversely, companies like Interactive Brokers chose not to pursue long duration investments and are in a far superior position. When asked about this in July 2022, Thomas Petterfy stated:

Jefferies Analyst: Hey. Good afternoon, guys. This is actually [ph] Jun (24:01) subbing in for Dan. I just wanted to ask what the recent hike in interest rates and the prospect of sort of more to come. How are you guys thinking about sort of the duration and the makeup of your investment portfolio? And to kind of like generate higher returns?

Thomas Pechy Peterffy, Chairman, Interactive Brokers: No, we are not. And that's the kind of risk that we do not want to take.

As a result, for IBKR, the fair value and carry value of their assets and liabilities are fairly close together:

As interest-rates have moved up, the fair value of SCHW’s securities portfolio has declined. In fact, as early as Q3 2022, just like SVB, the fair market value of SCHW’s tangible common equity turned negative.

At the same time, like SVB, clients have been pulling their deposits out of SCHW, down from $465bn in Q1 2022 to $367bn in Q4 2022. While SCHW has argued that they are at the ending stages of cash sorting, at any moment, when depositors realize SCHW’s precarious position, Charles Schwab risks encountering a similar run as the other financials, which would cause it become a forced seller of its securities (the effective margin call) to meet deposit withdrawal requests. If the withdrawals exceed the amount of their AFS portfolio, SCHW would have to start selling its HTM portfolio at a loss. The probability of this occurring has risen significantly since SVB’s implosion, making SCHW a poor risk/reward at its current valuation. We think when depositors’ game theory starts setting in, a variety of negative outcomes are possible.   

Comparing SCHW’s financial position with other financial institutions shows the relative predicament they are in:

And when incorporating the fair value of SCHW’s other assets and liabilities:

While SCHW is in a better position than SVB and FRC, with only 21% (or ~$71bn at high risk of departure) of uninsured deposits, versus 9% and 67% respectively for SVB and FRC, if depositors panic, the company is still in a precarious position. It simply comes down to game theory.  

Aggressive Accounting by Management

In 2020, management arbitrarily reclassified $135bn of HTM securities to AFS. Why? 

Because at the onset of the Covid-19 pandemic, when interest rates dropped (the 10-year treasury fell from 2% to 1%), this boosted the fair market value of the company’s securities. Since AFS securities are marked to market on the balance sheet, SCHW recognized a $7.2bn increase in the value of its equity that year. 

Conversely, in early 2022, when interest rates started to rise, SCHW would have recognized mark to market losses if it held it as AFS securities, and so management conveniently moved $105bn of AFS securities back to HTM, at cost. This action dented the blow felt on SCHW’s book value, and allowed the company to play with its capital ratios.

We are a bit skeptical of management’s assertion in today’s press release that HTM maturities are actually mature at par when management moves them freely: 

Further of note, even as Silicon Valley Bank discloses the fair value of their HTM securities on their balance sheet, SCHW chooses not to, instead disclosing it in their footnotes: 

“Opting out of AOCI” to Hold Less Capital

Instead of choosing to hold themselves to a higher capital requirement and protect investors with a greater buffer, Charles Schwab’s management chooses to opt for excluding AOCI from regulatory capital. Had they held themselves to the higher standard of peers like JPM, they would be in a significantly better financial position: 

“Capital requirements for Category III banking organizations include the generally applicable risk-based capital and Tier 1 leverage ratio requirements (the “standardized approach” framework), the minimum 3.0% supplementary leverage ratio, the countercyclical capital buffer, which is currently 0%, and the stress capital buffer. As discussed below, starting in 2022, CSC, as a large savings and loan holding company became subject to the stress capital buffer requirement, which applies to risk-based capital ratios (CET1, Tier 1 Capital, and Total Capital). Under the revised capital requirements, Category III organizations are not subject to the “advanced approaches” regulatory capital framework and are permitted to opt out of including accumulated other comprehensive income (AOCI) in their regulatory capital calculations. CSC made this opt out election, and commencing with the first quarter of 2020, excludes AOCI from its regulatory capital. Category II organizations are not permitted to opt out of including AOCI in their regulatory capital calculations and have additional requirements for calculating risk-based capital ratios and risk-weighted assets.”  (SCHW 10-K, 2022)

Cracks Forming

Deposits have started to shrink by $100 billion in the past 9 months, with unknown impacts following SVB’s collapse. Shrinking bank assets, little excess cash to absorb further outflows, and higher funding costs are all pointing towards deteriorating business fundamentals for the company.

Insiders have sold shares in February:

2/28/2023: Nigel Murtagh, Chief Risk Officer - 10,796 Shares - Price: $80.22

2/16/2023: Charles Ruffel, Director - 5,176 Shares - Price: $80.88

2/14/2023: Charles Schwab, Chairman - 28,775 Shares - Price: $80.65

2/13/2023: Charles Schwab, Chairman - 95,030 Shares - Price: $81.03

2/8/2023: Charles Schwab, Chairman - 62,500 Shares - Price: $81.54

2/7/2023: Charles Schwab, Chairman - 62,890 Shares - Price: $81.07

2/6/2023: Charles Schwab, Chairman - 62,890 Shares - Price: $80.02

2/6/2023: Charles Schwab, Chairman - 125,780 Shares - Price: $80.10

2/3/2023: Charles Schwab, Chairman - 129,030 Shares - Price: $79.76

2/1/2023: Charles Schwab, Chairman - 121,066 Shares - Price: $77.84

Once investors realize how little of a buffer SCHW’s management team has decided to operate with and the precarious position that has put the company in, we think the premium valuation that SCHW currently trades at no longer holds. At 6x-10x earnings, SCHW should trade at $26 to $43. And this is assuming no impairment in book value or earnings, which is a real possibility.     

Catalyst

Investors realizing the accounting movements SCHW has done the past few years, and the mark-to-market negative equity value that SCHW currently has.