As Silicon Valley Bank imploded and shares of regional banks tumbled earlier this month, investors ramped up their scrutiny of
—and sent shares spiraling downward. Executives, including founder Chuck Schwab, acted quickly to reassure investors. Shares rebounded, but at $53, they are down 36% this year and far below their 52-week high of $93.
Wall Street analysts suggest that investors, spooked by liquidity concerns everywhere, have overreacted. But there are clear reasons to be cautious toward the stock (ticker: SCHW). Rising interest rates and outflows of clients’ cash could take a sizable bite out of Schwab’s earnings.
It might seem strange that a company synonymous with investing got swept up in what is ostensibly a banking crisis. But Schwab owns a bank; one that holds brokerage clients’ idle cash in so-called sweep accounts. Last year, more than half of Schwab’s $20.8 billion in revenue came from net interest revenue, or the difference between the interest it earns on bonds and loans and the interest it pays on cash, primarily in its sweep accounts, which now yield just 0.45%.
With short-term interest rates at more than 4%, investors have been moving uninvested cash to higher-yielding options, engaging in “cash sorting.” It has been happening “rapidly,” says Devin Ryan, an analyst at JMP Securities. Schwab had $367 billion in deposits at the end of the fourth quarter, down 17% from a year earlier and down 7% from the third quarter. And, says Ryan, “it isn’t over yet.”
Schwab could bump up the rate it pays customers to stem cash sorting, but analysts don’t think it will. That’s because some portion of clients’ portfolios are apt to remain in cash for liquidity purposes, despite the low rates, and Schwab doesn’t really compete with traditional banks for deposits. What’s more, if it did bump up its rate on uninvested cash, earnings would likely take a hit.
Morningstar estimates that earnings would decrease by roughly 9% for each 0.25% increase in the cost of deposits. Schwab earned $3.90 in 2022 and Wall Street analysts polled by FactSet expected it to earn $4.88 a share in 2023 as of the end of last year. Now they are forecasting $4.07 a share.
A company spokeswoman said in a statement that Schwab regularly reviews the interest rates it pays customers and offers a range of cash solutions. “Clients should not leave money they intend for savings and investment needs in any sweep vehicle,” the spokeswoman said. “Ultimately, the choice of where to put uninvested cash is up to each client.”
The big unknown for Schwab, and for shareholders, is how long cash sorting endures. Schwab believes it will largely abate during 2023. Sweep account outflows in February were about $5 billion lower than January, and March month-to-date daily average outflows are consistent with February, according to the company. Not all of that money is leaving Schwab; some of it is going to the company’s other cash products that pay customers better rates, but which Schwab makes less profit on.
Longer-than-expected cash sorting could put more pressure on earnings. When outflows of client deposits exceed Schwab’s cash on hand and the amounts generated by maturing securities, the company taps other funding sources, such as Federal Home Loan Bank, or FHLB, loans, Schwab says. But that is a costly solution.
“When they have to replace that [departing] deposit with FHLB borrowings, which cost well over 4%, it becomes much more expensive,” Ryan says. Schwab’s “earnings power will be lower than we previously thought, as it accesses higher-cost funding sources and its deposit base shrinks,” Morningstar analyst Michael Wong wrote in a March 19 note.
“Assuming that interest rates stay relatively high compared to the previous 10 years, more clients may hold money-market funds or fixed income instead of leaving their cash in Schwab bank accounts,” Wong wrote. Steven Chubak, an analyst at Wolfe Research who is bullish on the stock’s long-term prospects, notes that April could be a bad month for cash sorting—“clients pull money to pay taxes,” he says.
In addition to the worries about cash sorting, investors are concerned about large, unrealized losses in Schwab’s securities portfolio. At year end, the company showed some $14 billion of unrealized losses on a “held to maturity” securities portfolio of $173 billion. Those losses exceed the firm’s tangible common equity, a key measure of its capital base; that stood at $7.9 billion at year end.
The portfolio, all government-backed mortgage securities, has lost value because of rising rates. The fear is that Schwab might have to start selling those securities, and realizing the losses in its earnings statement, to meet stepped-up cash withdrawals. That’s what happened at Silicon Valley Bank.
The Schwab spokeswoman said the company has access to ample sources of cash and a large enough portfolio of “available for sale” securities—$148 billion as of Dec. 31, already marked to market values—to meet liquidity needs. Given that, “there is almost zero chance” Schwab would be forced to sell securities in its held-to-maturity portfolio before maturity, the spokeswoman said.
CEO Walt Bettinger told The Wall Street Journal that the company would have sufficient liquidity even “if 100% of our deposits ran off.”
Yes, Schwab does have a lot going in its favor, not least its scale: 34 million account holders and $7.4 trillion of client assets. It remains a trusted home for investors in stocks, bonds, and funds. But with the market jittery and interest rates still on the rise, the next few quarters could be a slog for Schwab’s own stock.
Write to Andrew Welsch at firstname.lastname@example.org