Schwab's chief financial officer explains to Goldman Sachs analyst that 'headline risk' makes unviable the tempting path to pay down $65 billion of burdensome loans -- and ring up 'instant earnings,' a second analyst says
Michael Verdeschi says wryly Schwab's balance sheet is a 'popular topic,' but company will stay the course despite the costs of carrying expensive liquidity loans.
5 min read- Schwab's stock jumped after reducing balance sheet leverage and supplemental borrowing.
- CFO cites 'headline risk' as reason to avoid paying down $65B in high-interest loans.
- Analysts see immediate earnings boost from selling underwater securities, but acknowledge loss risk.
Shares of Charles Schwab Corp. reached their highest price since July after revealing it knocked off $9 billion in “supplemental borrowing” and cut balance sheet leverage by over 30% from peak levels back in May 2023.
The $10-trillion financial giant's shares jumped yesterday (Oct. 5) from an opening of $67.86 to close at $71.96.
They edged up today to finish at $72.08, a 0.17% gain. Shares slipped back to $71.99, down 0.12%, in after-hours trading, but they are a far cry from their 52-week low of $48.66.
Still, $65 billion in necessitated loans outstanding hung heavy over yesterday's Wall Street earnings meeting – the word “supplemental” was uttered 22 times on the call.
Goldman Sachs analyst Alexander Blostein asked if Schwab might reconsider that expensive burden of a solution now that cash sorting is “stabilizing."
Schwab Chief Financial Officer Michael Verdeschi said borrowing is a problem that transcends sharp-penciled calculations.
“That certainly remains a popular topic within the investment community and I appreciate that question, but it is something that we’re not currently pursuing,” he said. "And as we’ve said in the past, we do not want to create, unnecessarily, headline risk that could disrupt our trusted relationship with clients.”
Schwab's largest trusted clients are its 15,000 RIAs with $4.6 trillion in combined assets who need to present “Schwab” to their clientele as an impenetrable vault.
Covering the float
Schwab assures it has financial muscle to shrug off billions of dollars in unrealized bank losses, but interest rate blunder exposes vulnerability if Fed hikes continue, analysts say
Schwab's stock was bolstered not only by showing robust earnings but also by reducing balance sheet leverage, battered by a staggering $19.4 billion in paper losses during last year's third quarter on its bank's bond purchases.
Patching over those paper losses meant getting third-party loans – at an expense extraordinary to Schwab's normal overhead.
CEO Walt Bettinger and founder Charles “Chuck” Schwab made clear from the start of the Fed-induced interest rate squeeze in March 2023 that Schwab would dodge write-downs on the devalued bonds by simply holding them to maturity. See: Schwab assures it has financial muscle to shrug off billions of dollars in unrealized bank losses, but interest rate blunder exposes vulnerability if Fed hikes continue, analysts say
The strategy worked; the squeeze sank for major banks, but Schwab Bank survived – at a cost.
The problem with that solution is the high cost of floating those investments over three- to five-years.
Headline risk
Story Timeline
Analysts are rooting for Schwab to write off its bad loans because of the upward impact on earnings, says Jonathan Holtaway, the former long-time bank analyst who is now president and manager of Ategra Capital Management, a private equity firm and asset manager in Vienna, Va.
“They are talking about selling the underwater securities in the bank’s portfolio. This would free up liquidity that could be used to pay down the supplemental funding,” he says.
“If Schwab sells the securities, it allows the money to be reinvested at a higher rate, instantly improving earnings," he adds.
Walt Bettinger comes out swinging during analysts' call, and shares pop, on assurances Schwab can ride out gale force interest rate pressure on its balance sheet
“The downside to doing this is they would have to realize the loss on the securities – a big loss – and that is the ‘headline risk.’”
“Imagine the headline: ‘Charles Schwab reports billions in losses.' It also would impact their regulatory capital ratios, whereas the mark-to-market losses are not included in capital.”
Not now…
Verdeschi did not rule out selling the under-water bonds in the future, but his “analysis” makes it preferable to stay the course for now.
“We do have an analysis. We keep that analysis fresh by looking at what a restructuring could entail. But for the reasons that I mentioned, not at this time.”
Holtaway says other companies did, in fact, rip off the band-aid to accept the losses and that shareholders rewarded them – headline risk be damned.
“A lot of companies did this last year and those that did generally saw a bump in their stock price."
Normalized earnings power
Still, he allows that Schwab may be a special case.
"Schwab’s situation is a little more egregious than most though in terms of scale of bond, mark-to-market losses versus their capital,” he said.
What might make Schwab's portfolio woes more “egregious” is the sheer scale of those losses, relative to peers beset with interest rate squeeze woes.
Schwab's timing – hence “normalized earnings power” – might change if more investors allocate more funds to cash, which is what allowed Schwab to knock off $9 billion in supplemental borrowing in the past quarter, Verdeschi said.
“The exact timing for achieving our pay-down goal will also be influenced by some of the same factors that we see in our transactional cash trends," he added.
"Over the near term, continuing to reduce the amount of supplemental funding outstanding is a key driver in achieving normalized earnings power, and we expect to show continued progress from here.”
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