October 17, 2023 | First a big thank you to our readers for the questions and comments on bank earnings. Below we summarize the Q3 2023 results for Charles Schwab (SCHW). One reader recently asked us if we were “bearish on SCHW,” but in fact we love the Schwab model. We dislike how the reckless actions of the FOMC in 2019-2023 almost caused an important financial institution with over $7 trillion in customer assets to fail.
The first thing to note is that even though the bank is earning more money on its investment and loans, SCHW is taking less down to the bottom line. When you hear a Buy or Sell Side pundit talk about how higher interest rates are "good for banks," remind them that book value of equity for financial institutions typically falls in periods of rising interest rates. The most recent five years has seen the return on earning assets fall dramatically for all banks. This is called "financial repression" for those of you unaware.
Note in the table above from the Q3 2023 SCHW earnings release that interest expense has risen 560% in the first nine months of 2023 compared with the same period in 2022. Over that same timeframe, interest revenue rose only 45%, illustrating how the interest rate arbitrage that made sense in 2020 and 2021 has disappeared with the Fed’s increase in short-term interest rates. This “trade,” if you will, motivated SCHW management to grow their balance sheet to take advantage of ultra-low interest rates, a trade that is now being unwound.
The chart below shows the total assets of SCHW going back to 2019, when our esteemed Fed Chairman Jerome Powell panicked and began to push down short-term interest rates. This change in FOMC policy incentivized names like Silicon Valley Bank and SCHW to put more sail up on the mast and take advantage of low funding costs. As the chart below illustrates, the SCHW balance sheet is now shrinking rapidly.
Source: EDGAR, FFIEC
As net interest revenue shrinks, the importance of the $7.8 trillion in SCHW advisory business grows. This is the point of SCHW as a business, not the bank's balance sheet. The bank was a secondary feature of the SCHW business until Chairman Powell stepped on the gas and drove interest rates into the floor and kept them at zero for years. SCHW swelled in size until the depository actually surpassed U.S. Bancorp (USB) in total bank assets, but with a balance sheet focused on securities rather than loans.
As the balance sheet of SCHW has started to shrink, the bank’s exposure to the gyrations of the bond market has also declined. Available for sale securities have fallen 50% over the past year, but held-to-maturity securities have risen 69% YOY. Deposits have continued to fall as the bank sheds assets and liabilities, while LT debt grew modestly. The result of all of these changes is that SCHW’s accumulated other comprehensive income (AOCI) was essentially flat in Q3 2023.
Source: EDGAR, FFIEC
As the SCHW management team shrinks the bank’s balance sheet, the stock price has fallen to reflect the changes. The anomalous growth in the bank’s equity market valuation that saw SCHW outperform industry leaders like JPMorgan (JPM) is now at an end, suggesting that the days of the bank trading at 4-5x book value are probably over without some new catalyst. The key question for investors is to ponder what the run-rate revenue and earnings of SCHW will look like over the next several years as the bank shrinks further.
Bottom line for us is that we like the SCHW business in terms of risk-adjusted equity returns, but the process of right-sizing the bank to a more sustainable level of assets will probably not endear the stock to investors. All banks in the US are going to be under pressure to shrink assets as the latest era of Fed-induced asset inflation ends. The days of SCHW trading at a significant premium to larger banks like JPM may be over.
If and when the FOMC decides that it must expand its already swollen balance sheet to prevent a credit default by the U.S. States Treasury, banks like SCHW with a heavy focus on investments in securities will also grow in size, but real equity returns will be diminished. It is notable that equity returns at SCHW have been growing even as the size of the bank has been declining. But with the SCHW equity market valuation now falling back to earth, look for this relatively small bank to possibly be acquired at some point in the future.
Source: Google Finance
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