Charles Schwab Corp. gets over 'hump' after furious bond rally takes bite out Schwab Bank's $19.6 billion in unrealized losses, though debt overhang could still take a decade to erase

Charles Schwab Corp. realized about a $4 billion improvement in its bank's “unrealized losses” during its fourth quarter, a small lightening of its load and a larger brightening of its 2024 horizons.

The Westlake, Texas, giant's bank – reeling in March and April under interest rate shocks that drove its fixed income assets deep underwater – has now weathered the worst of the storm.

A year-end bond rally staved off a third straight annual decline across the wider market, too. See: Schwab assures it has financial muscle to shrug off billions of dollars in unrealized bank losses.

“Schwab [is] definitely over the hump, but still [holds] a lot of paper losses,” says former banking consultant Jonathan Holtaway, now president and manager of Ategra Capital Management, a private equity firm and asset manager in Vienna, Va.

“[My] best estimate for Schwab would be [its bond losses are] about where they stood at the end of the second quarter, 2023," Holtaway says, via email.

At the end of the second quarter, June 30, Schwab showed unrealized losses of $15.6 billion on its held-to-maturity bond investments, largely from mortgage-backed securities, treasuries, and corporate debt, according to 10-Q filings.

Dodging a bullet

Charles Schwab Bank, an FDIC insured subsidiary that is separate and insulated from Schwab's brokerage and RIA custody units, bore the brunt of the ‘paper’ losses.

Schwab was counting on a 75-basis-point rise, only to see the Fed hike rates by 425 basis points in a matter of weeks, after it made its call. 

The bank was pushed to the edge of a precipice, according to analysts, including Holtaway, who questioned whether it could survive a further 100-basis-point Fed rate hike.

Yet now, with bonds rallying and interest rates set to fall, possibly in 2024, unrealized bond losses are falling as well. 

Schwab also passed a major Fed stress test, Jun. 28, as did all 23 other firms. 

Stock rebound

Schwab's stock (SCHW) is also climbing out of a hole. It closed today (Dec. 27) at $69.27, up 32 cents or 0.46%. But shares are still down 20.4% from their 52-week high of $86.63.

The stock was hammered last February after the extent of its unrealized losses became more widely known. 

They plunged near 33% over a few days, before Schwab founder and co-chair Charles ‘Chuck’ Schwab and CEO, Walt Bettinger released a rare letter, assuring the market it could ride out the storm.  

Schwab's shares hit a 52-week low of $45 in April. They've climbed 53% since then.

The pair said the fear over Schwab's unrealized losses was borne out investor and analyst confusion rather than a real assessment of risk.

Its balance sheet and cash flow were more than able to withstand a sustained bond market slump, they noted. 

Fortunately, Schwab was spared a run like the one that sank Silicon Valley Bank, which collapsed after it couldn't cover withdrawals from sustained losses, selling underwater assets.

Nor did Schwab do anything outside the scope of what a bank should do, according to Jeffrey Young, CEO of DeepMacro, in an email.

"The idea that banks don't take interest risk is sort of ludicrous. Banks exist to take interest rate (and other) risk! They have to do it properly, of course, but just the mere fact that they took interest rate risk is not a problem in itself. 

“Banks had to hold treasuries. Banks cannot sell their holdings all at once, Nor can they all hedge them all at once.”

Rate logic

The continuing bond market rally likely couldn't come soon enough for Schwab.

If Holtaway's back-of-the-envelope estimates prove correct, Schwab may already have reduced its paper losses by as much as 20% – a figure that tracks with the wider industry.

Bank of America, which was holding $131 billion in unrealized bond losses at the end of September – the largest in the industry -- now holds around $100 billion – a 24% decline, Barron's reported Dec. 18.

Schwab experienced a greater market shock from holding long-term bonds because debt up the bulk of its holdings, like Silicon Valley Bank.

Most commercial banks diversify their portfolios through loans and other instruments; Schwab uses 90% of its depositor cash to buy U.S. Treasuries and other high-grade debt. 

Its loan portfolio accounts for only about 10% of its cash, according to the company.

Bonds rally

The bond rally is largely driven by the expectation among investors and analysts that rates will soon fall – an expectation fueled by the Fed, which has published guidance that it will cut interest rates by 75 basis points next year.

As a result, treasury yields are falling, and bond values are climbing, to the extent that investors now hold the biggest overweight bond position since 2009, Reuters reports.

In the year-to-date, bonds, including interest payments, have returned 4.8% to investors, compared to a negative 13% by year-end 2022, according to data from Bloomberg's US Aggregate Bond Index.

A tale of teetering

The crisis began when the Fed threw a curveball at Schwab and many other financial firms. 

In Dec. 2021, the Fed foresaw rates rising by a modest 75-basis-points by Dec. 2022. But the economy's rapid recovery from the COVID lockdown, coupled with the Russian invasion of Ukraine, caused inflation worldwide to spike. 

The Fed reacted by kicking up rates by 425-basis-points in rapid-fire succession. 

With the Fed rate just below 5% in late February into early March, industry observers and investors began to openly discuss whether Schwab could lose its banking arm.

"One hundred basis points above the previous 10-year treasury peak would be enough to cause a client exodus crisis, absent a serious capital raise," Holtaway cautioned earlier this year.  At the time, the Fed rate was 50 basis points lower than now, at 4.9%.

Gathering storm

GQG Partners, one of Schwab's biggest shareholders, dumped roughly 1% or $1.4 billion in stock, citing worries over the unrealized losses. 

A surge of investors moving deposits into money market funds would likely crimp Schwab's future growth, the FT reported April.

GQC likely booked a large loss of its own, given it bought the bulk of its stake in Schwab in the third quarter of 2022.

Schwab's share price stood at $63.92, Jul. 1, 2022, and GQG sold in early 2023. On Apr. 6, Schwab shares traded at $49.35.

“We didn't see an existential risk, but they were caught up in the sentiment around banks,” Mark Barker, GQG's international head, told the FT.

"With all the inflows to money-market funds, Charles Schwab is losing deposits revenue," he added.

A 20% clawback

The 43% surge in Schwab's unrealized losses in just six months – from $13.6 billion, Mar. 31, to $19.5 billion, Sept. 30 – could still prove problematic, since it likely locks Schwab into low-yield portfolios for, perhaps, years.

By the end of the third quarter of 2023, the losses stood at just over double Schwab's total tangible equity, or book value less debts.

Schwab's unrealized losses in the third quarter – as Treasuries hit their lowest value since 2007 – also represented one of the largest paper losses by a leading domestic bank relative to available capital, Barron's reported Nov. 12.

JPMorgan, which has around $30 billion of unrealized losses, and Bank of America, which has roughly $100 billion in unrealized losses, have far higher tangible equity – $186 billion and $200 billion, respectively, compared to Schwab's $9.7 billion, according to Barron's.

Schwab raised $2.5 billion of long-term debt in May 2023, due in 2029 and 2034 at a 5.64% with a 5.85% yield, respectively, almost double the 2.9% yield it sold 10-year bonds at in 2022, according to WSJ data.

No sale

Schwab is also unlikely to sell many of its bond holdings for the time being, at least not until the losses it accrued locking into previous Fed guidance fall further, according to Holtaway.

“I don’t think they will do a security sale this quarter,” he says.

For accounting purposes, a large swath of Schwab's bond portfolio is classed as held-to-maturity, meaning the firm has no need to sell the bonds before they mature. 

As a result, it can avoid the current paper losses – a fact the firm emphasized in March.

In total, Schwab holds $162.5 billion of held-to-maturity bonds, and the majority will not mature for more than a decade.

It also holds $11.8 billion of unrealized losses in its $122.1 billion available for-sale bond portfolio, according to company filings.

“Given our ongoing significant access to diversified sources of liquidity, the composition of our deposit base, and our high levels of profitability, there is a near-zero chance Schwab would need to sell any of its investment securities prior to maturity,” a company spokesperson told Barron's in November.

Money market boon

The anticipated rate decreases fueling the bond resurgence may have other gifts to give. 

The spread between the Fed rate – roughly 5.5% today – and what Schwab's cash sweep pays out – 0.45% – is less a sweet spot that it seems.

Interest rates reached a tipping point in the last year, causing investors to began to move assets out of investment accounts to chase higher rates. 

As a result, Schwab's bank deposits had fallen roughly 30% year-over-year by Sept. 30 --from about $641 billion to $452.6 billion  – while Its money market fund assets surged 106%, from $211 billion to $436.3 billion, according to company filings.

In June, Schwab chief financial officer, Peter Crawford, labeled the process a “client cash realignment trend."

By the end of the third quarter 2022, total US money market fund assets stood at $5 trillion and rose to $6.3 trillion by Nov. 30, 2023 – a surge of 25%, according to data gathered by the Securities and Exchange Commission (SEC).