Schwab's Buy of 'Crown Jewels' Escalates Battle With Wall Street Biggies

The longest bull market in history has created a growing class of U.S. investors flush enough to upgrade their computers, their kitchens and their cars. And many of those investors, who got rich trading with the likes of discount giant Schwab (SCH Quote), have chosen to upgrade to full-service brokers, too.

But that's all about to change, if Schwab's proposed $2.7 billion acquisition of bank-for-the-wealthy U.S. Trust (UTC Quote) works as planned. The deal is richly priced but worth it, in Schwab's view, because it will help to combat one of the San Francisco brokerage's main problems in recent years: Holding on to the increasingly lucrative -- and competitive -- business from customers whose accounts grow fat on stock-market appreciation.

The deal also renews Wall Street's focus on the tug-of-war for investors' hearts and assets that Schwab is waging with integrated brokerages such as Merrill Lynch (MER Quote) and Morgan Stanley Dean Witter (MWD Quote), which have benefited from clients' growing wealth and the full-service firms' broader offerings.

Exodus

Schwab has had a good run during the past few years, more than doubling assets to over $700 billion and customer accounts to more than 6 million. But with full-service firms such as Merrill and Morgan Stanley peddling the $29.95 trade that has been Schwab's staple, holding onto hard-won accounts has become a concern.

"We estimate our attrition levels at roughly about 6% annually," Schwab co-CEO David Pottruck told analysts Thursday morning. But with the U.S. Trust deal, "I would say that we would see ourselves within two years cutting [attrition] back at least by one-third, if not by a half."

Attrition was evidently a big enough concern that Schwab felt compelled to pay a 60% premium to U.S. Trust's closing prices Wednesday. But Chase H&Q analyst Greg Smith notes U.S. Trust was trading at about a 20% discount to the other publicly traded trust company, Northern Trust (NTRS Quote).

Schwab CFO Chris Dodds told analysts at the conference that while the firm realizes the acquisition came at "healthy premium," U.S. Trust "is a crown jewel and worth every penny."

Pricing U.S. Trust's services for the maturing Schwab customers may be the most significant hurdle, but executives at both firms told analysts they're planning to employ Schwab's technology to create more cost-effective products.

Upping the Ante

As for the fast-evolving financial-services business, "Schwab has answered the competition and raised the ante," says Michael Flanagan, an independent securities-industry analyst. "A lot of the full-service firms are going to have to scurry to expand their trust banking services. This is one very significant factor in Schwab's offer."

But not everyone is going to be so willing to jump on board, Smith suggested. More than $200 billion of Schwab assets are managed through its network of independent financial advisers, which could raise the hackles of some Schwab workers. "This will step on some of their toes," the Chase H&Q analyst says. "But those guys face competition from everywhere." Chase H&Q hasn't done any underwriting for Schwab, but has a research agreement with it.

Having first approached U.S. Trust in February 1999 before working through the agreement with the Charles Schwab, the brokerage's founder and co-CEO, Pottruck was clearly enjoying another decision he made more than two years ago. Going to U.S. Trust -- as a customer.

The Street may be wondering where else Pottruck has accounts.