Rate rises test Charles Schwab’s tactics in US brokerage price wars

Charles Schwab’s war on fees has come home to roost, as rising interest rates sour the largest US broker’s big bet on customer cash.

Under pressure from low-cost start-ups such as Robinhood, Schwab shook its industry in 2019 by eliminating trading fees, then one of its big revenue streams. The move seemed decisive in a long industry-wide price war, letting it outflank low-cost competitors such as ETrade and TD Ameritrade and become the largest retail brokerage in the US with $7.4tn in client assets.

The bet that Schwab could win customers with low fees and profit by investing the cash that they kept on its platform initially proved to be an extremely lucrative one. But interest rates have risen at speeds not seen for decades and Schwab’s cash play has unravelled, sending its shares down almost 40 per cent this year.

The broker’s earnings, which it reports on Monday, will face scrutiny by investors concerned about its similarities to Silicon Valley Bank, which failed last month, sparking a sell-off of regional bank shares. Schwab’s stock has not recovered, and one of its largest investors, GQG, disclosed this week that it had sold its entire $1.4bn stake at the height of concerns over paper losses in Schwab bank’s bond portfolios.

In a statement, Schwab emphasised that it was different from the banks caught in March’s sell-off, saying that its share price did “not reflect the strength of our business”.

Schwab has a banking licence and analysts say that it began acting more like a lender than a broker in recent years. As customers deposited their savings and Covid-19 stimulus cheques on to the platform and markets climbed, Schwab automatically “swept” the money into bank accounts.

That made it one of the 15 largest banks in the US by deposits, earning $10.7bn in net interest in 2022 from customer cash on its platform, up by a third from 2021.

While most banks use client deposits for lending, Schwab invested them into secure, long-dated bonds and mortgage-backed securities. But as with SVB, many of those investments lost value as rates rose. At the same time, Schwab’s clients have been moving cash into higher-yielding investments at speeds that caught it off guard.

Schwab was forced to take out expensive loans in the fourth quarter of 2022 as more than $43bn moved out of its cash accounts — though that money may remain in its brokerage, Piper Sandler noted, as clients chase higher rates in a process known as “cash sorting”.

Critics and analysts say the problems with Schwab’s cash play worsened this year.

“They never expected the bond losses to get so big,” said Porter Collins, a short seller and co-founder of Seawolf Capital, who is known for his former firm’s short position during the 2008 housing market crash.

Seawolf has taken out short positions on Schwab in the past year, expecting that the money it was making on cash would tumble. Because US authorities do not consider Schwab to be systemically important, “no one was paying attention to the capital ratios on [its] balance sheet,” Collins said.

Analysts and investors have long been concerned about how Schwab’s strategy would be affected once interest rates began to rise. Customers who were once content to leave money in bank accounts that paid very little interest are now moving record sums to more lucrative alternatives.

“The brand is fine; the way they make money is not,” said Christian Bolu, an analyst at Autonomous Research. “The assumption is that a certain level of cash would always be in an account. But that assumption has been put to the test.”

Thomas Peterffy, billionaire founder of Interactive Brokers, a Schwab rival, said rising interest rates were changing how brokers made money.

“For a while, they were making a lot of money, and we were making very little money,” Peterffy said of Schwab. His firm has traditionally paid interest rates closer to the US Federal Reserve’s headline rate because its more sophisticated customers demanded it. “We didn’t really have a choice. And now we are making a lot of money, and they are not.”

“Schwab’s target is the mom and pop investor,” he observed. Now, federal interest rates are too high for those traditionally reliable customers to ignore by parking cash in low-yielding accounts.

Analysts have lowered earnings forecasts for Schwab in light of recent outflows, estimating that its customers may have moved as much as $55bn out of its bank in the first quarter, as the assets into which it had invested their deposits lost value.

“They can’t sell the assets because they’re under water, and since they can’t sell [them] they’re replacing [them] with borrowing,” said Brennan Hawken, a UBS analyst. Schwab’s underwater assets are expected to yield about 2 per cent when they mature, but the cash it borrowed to avoid taking losses will cost it closer to 5 per cent, UBS estimates.

Schwab has expressed confidence in its business, with its typically media-shy chief executive Walt Bettinger telling CNBC that he had recently purchased 50mn shares.

The broker announced more than $53bn in net core inflows in March, up from $42bn the previous month, though analysts note it is not yet clear whether those funds went into cash or to Schwab’s brokerage and money market funds.

Analysts said that while they expected Schwab’s net revenue to fall almost 32 per cent from the fourth quarter to $5.1bn, this would still be up 11 per cent from the first quarter of 2021.

“Fears they’re going to lose money are not even in the ballpark,” said Rich Repetto, an analyst at Piper Sandler.

If rates soften, rising yields will boost the value of some of Schwab’s investments. But, Hawken said, the brand still faces headwinds. “The earnings engine isn’t as strong as they thought it was. They built the engine around cash, and [cash] sorting is a flaw in that engine.”