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Thursday, July 17, 2008


charles schwab bank

like a great many people, i use a discount broker to trade. and like a great many discount brokers, mine -- schwab -- sweeps my cash balances into an FDIC-insured deposit account on which they pay nearly no interest. it serves the brokerage very well, as it is far more profitable for them to use their clients' idle cash to make loans than it is to run the money market fund that used to hold all that cash.

but the loan business has clearly grown hazardous since 2003, which is when schwab followed the lead of merrill lynch and many others in establishing their bank. and being a san francisco-based establishment -- officially reno, nevada, for the bank -- i've been suspicious of what exactly schwab might be holding with the cash they borrow from me.

let me say first that i am not a bank analyst. this is amateur sleuthing, and i welcome criticism.

using the regulatory FFIEC thrift financial report (TFR) data provided quarterly by schwab bank (technically a thrift, FDIC cert# 57450), one can see their past due and nonaccruing loans, and further calculate their texas ratio. this is an exercize i've indulged in with other banks through the FDIC call reports. for example, in the 1q2008 i estimated the texas ratio of national city to be about 71% (in desperate need of capital) -- and the same for marshall & ilsley of around 33% (with a guess at 2q following a scary conference call being 40%, bad and getting worse fast).

schwab bank, however, i found to be reporting just $23mm in troubled loans over nearly $900mm in tangible equity (that is, total equity less intangible assets) in 1q2008 -- a texas ratio around 3%. they carried virtually no REO.

this is a bank with nearly $16bn in assets. just $23mm in past due and nonaccruing loans into the worst housing cycle since the depression? for a california bank? something smells.

it took a bit of digging, but this paper from the chicago fed -- "who holds the toxic waste?" -- hints rather obliquely at where the body is buried.

as of 4q2005, schwab bank was one of the most deeply involved FDIC members in the country in collateralized mortgage obligations on an absolutel level, not to mention as a percentage of assets and of capital. their 4q2005 TFR showed that, of the $3.7bn in securities shown on schedule RC-B, fully $2.0bn -- in relation to $6.8bn in total assets and $540mm in tangible equity -- was private label CMOs, the difference being GSE instruments.

and this has if anything deepened in the time since the fed report was authored, per the FFIEC call report -- in 3q2007, of schwab's $13bn in assets, $8bn were MBS (inclusive of CMOs). of these, $2.8bn was held GSE instruments while $3.5bn was private-label and $1.5bn were 'other domestic debt securities' (which could be corporates or other flavors of securitized debt). that would be 445% of tangible equity ($787mm) in private-label MBS/CMOs alone -- headed into what has been an unmitigated disaster for mortgage-backed instruments of all kinds. there is no general valuation allowance set against the portfolio at all; this continued to hold true in 1q2008.

it has been discussed ad nauseum in the financial blogs how wall street is assiduously avoiding even realistic marks (much less marking to market) on the vast majority of asset-backed securities (most particularly those that are not backed by subprime mortgages). but as prime mortgage performance deficiency accelerates, this can not hold. these securities will find a mark at some point. and even if schwab bank's portfolio is of the highest caliber of private-label CMOs, those marks will be extremely damaging to capital. markit's ABS AAA-HE index for the second half of 2007 is indicating such instruments to be valued at less than 50 cents on the dollar. even if we presume that the ABX index is overwrought (as it may be), it would take only 80 cents on the dollar of schwab's portfolio to eradicate the bank's equity stake.

the position of merrill's banks is similar, though of course they aren't standalone publicly traded entities. but one has only to go back a few months to remember the reaction when merrill first revealed its huge CMO exposure through its banking units.

the fed's working paper from that long-ago era of naivete known as 2006 all but dismissed the loss of principal as a risk -- it was concerned far more with prepayment risk in a rising interest rate environment to banks with high levels of CMO exposure. that concern has faded, obviously, for the moment.

to be sure, it is possible that schwab has so effectively hedged their default risk that they are not experiencing significant difficulty. but that certainly hasn't been the case for the much-scrutinized merrill, which as an investment bank makes hedging its business. and an examination of schwab's 9/30/7 TFR schedule RC-L shows no credit derivatives whatsoever. (though it does show $2.6bn in undrawn HELOCs.) merrill's bank, in contraposition, was the beneficiary of about $8bn in credit default swaps in that period.

it's quite odd that schwab bank is reporting such minimal past due and nonaccrual on its whole mortgage portfolio -- the 1q2008 report further shows that the bank claims not to have foreclosed on anyone in the quarter, which is difficult to imagine in this environment. schwab publicly attributes the fact to "ongoing financial discipline", which strikes me as a bit too thick a layer of self-serving corporatespeak to be true. but the potentially unhedged exposure to CMOs is what should really drive nervousness surrounding this bank, in my (admittedly amateur) opinion. i'll be more careful not to leave cash balances over the FDIC insurance limit uninvested in schwab's brokerage accounts, instead channeling unused funds into treasury-backed money market shares.

one should further note, however, that the broader firm charles schwab & co., of which the bank is a subsidiary, would probably shoulder the implosion and writeoffs on a $4-5bn subsidiary CDO portfolio without existential threat.

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So, your point is...?

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Very interesting, especially in light of what has happened since you posted this. Today, Schwab stock hit a new low. My "broker" at Schwab has been after me to sign some papers esentially changing my brokerage account to a bank account. You may be an amateur, but your reasoning seems sound to me. Besides, look how well the so-called pros have done in assessing this mess.
Based on your essay and other warning signs, I'm going to transfer some of the money I have in my Schwab accounts. Thanks.

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Yes, you are an amateur. You really have no idea about which you speak. In July, there were no foreclosures. Schwab was not dealing in nasty loans like other banks. Perhaps before you go around trashing a company, you should get your information correct!

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Yes, you are indeed a pure amateur who knows not from which you speak. Schwab bank avoided the toxic loans and they rid themselves of those CMO's years ago. Try using info that is more current than 4 years ago. Schwab is a great company and is fiscally strong and is well managed. Have a problem with that? Go stick your money under a mattress just like you do with your head in the sand.

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