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The First National Bank of Charles Schwab


While everyone else is trying to avoid being a bank, Schwab doubles down.

Last week, while all eyes were on Wall Street and how the Street would skirt the newly announced "Volcker Rule" aimed at our largest banks and investment banks, Charles Schwab (SCHW) moved further into bank-dom, selling $500 million in new common stock "to support balance sheet growth, including expansion of the Company's deposit base and potential migration of certain client balances from money market funds into Schwab Bank..."

Given everything else that was going on, I can see how this deal slipped through the financial media's sights, but I think the Schwab story warrants at least a little bit of attention.

As I see it, the deal represents what a corporation does when, put in a bad position, it's forced to choose the least-bad alternative. For Schwab, and many other brokers and money managers, its problem is one of those unintended consequences of the Federal Reserve's desire to maintain near-zero short-term interest rates in an effort to recapitalize the banking industry.

For money market fund managers, near-zero interest rates have eviscerated their once enormous "cash cow." To prevent investor yields from actually going negative, Schwab (and just about every other money fund manager) has been forced to rebate most, if not all of its advisory and administrative fees. And things have gotten so bad that some fund managers have either closed their money funds to new investors or have put gates on their funds in order to limit additional inflows.

For Schwab, that choice isn't really available as cash in its brokerage accounts needs to swept somewhere.

So Schwab is following in the well-trod steps of its banking brethren, and instead of sweeping client cash into money funds -- on which it loses money -- it's putting the money into the deposits of an affiliated bank, figuring that by "borrowing" short using money fund sweep funds and lending long through longer maturity loans and securities holdings, it can more than break even.

As of the end of September, Schwab Bank had over $30 billion in assets funded through sweep deposits. Based on its equity offering, Schwab clearly thinks its bank is going to need to grow even bigger.

But for Schwab clients, there's a difference between being a money fund investor and a depositor. As a Schwab depositor, sweep clients get whatever rate Schwab Bank sets for its deposits. And while Schwab Banks holds a diversified portfolio of assets, Schwab depositors have single counterparty credit exposure -- the Bank.

For Schwab shareholders there's also a significant difference between owning a broker dealer/money manager and owning a bank. As Schwab Bank grows, additional capital is likely to be required by the banking regulators. And now Schwab shareholders, rather than just Schwab money fund investors need to understand what "investment" decisions are being made as Schwab shareholders stand first in line, ahead of depositors, in case of credit issues.

Understand, I'm not suggesting that what Schwab is doing is necessarily wrong. And as I wrote above, it's hardly the first firm to make this transition.

But the risks have changed. And somehow I suspect that neither Schwab shareholders or clients even noticed.
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Position in SPY,SRS and JPM.
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