Wells Fargo & Company Bonds: A Second Stage Analysis

Institutional investors around the world are required to prove to their audit committees, senior management, and regulators that their investments are in fact “investment grade.” For many investors, “investment grade” is an internal definition; for many banks and insurance companies “investment grade” is also defined by regulators. We consider whether or not a reasonable U.S. bank investor would judge Wells Fargo & Company to be “investment grade” under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated from U.S. government regulations.  Section 939A states the following:

“SEC. 939A. REVIEW OF RELIANCE ON RATINGS.

(a) AGENCY REVIEW.—Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review—
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(b) MODIFICATIONS REQUIRED.—Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(c) REPORT.—Upon conclusion of the review required under subsection (a), each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection (b).

The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:

“In this rulemaking, the OCC has amended the regulatory definition of ‘investment grade’ in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is ‘investment grade,’ banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution’s risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised ‘investment grade’ standard.”

Assuming the recovery rate in the event of default would be the same on all bond issues, a sophisticated investor who has moved beyond legacy ratings seeks to maximize revenue per basis point of default risk from each incremental investment, subject to risk limits on macro-factor exposure on a fully default-adjusted basis. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Wells Fargo & Company.

Term Structure of Default Probabilities

Maximizing the ratio of credit spread to matched maturity default probabilities requires that default probabilities be available at a wide range of maturities. The graph below shows the current default probabilities for Wells Fargo & Company ranging from one month to 10 years on an annualized basis.  The default probabilities range from 0.04% at one month (up 0.02% from July 17) to 0.02% at 1 year (up 0.01%) and 0.10% at ten years (up 0.01%).  The green line is the current default probabilities and the yellow line is the default probabilities as of our prior report, which used data for July 17, 2013.

We explain the source and methodology for the default probabilities below.

Summary of Recent Bond Trading Activity

The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds.  We used the TRACE data described above in today’s analysis.

The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Wells Fargo & Company bonds.  The lowest curve, in dark blue, is the yield to maturity on the benchmark U.S. Treasury bonds most similar in maturity to the traded bonds of Wells Fargo & Company. The second lowest curve, in the lighter blue, shows the yields that would prevail if investors shared the default probability views outlined above, assumed that recovery in the event of default would be zero, and demanded no liquidity premium above and beyond the default-adjusted risk-free yield.  The third line from the bottom (in orange) graphs the lowest yield reported by TRACE on that day on Wells Fargo & Company bonds. The fourth line from the bottom (in green) displays the average yield reported by TRACE on the same day.  The highest yield is obviously the maximum yield in each Wells Fargo & Company issue recorded by TRACE.

The data makes it very clear that there is a very large liquidity premium built into the yields of Wells Fargo & Company above and beyond the “default-adjusted risk free curve” (the risk-free yield curve plus the matched maturity default probabilities for the firm).

The high, low and average credit spread at each maturity are graphed below.  While there is a fair amount of volatility in spread prevailing on the shorter maturities, credit spreads are gradually increasing with the maturity of the bonds. For the convenience of the reader, we have added a smoothed line fitted to average credit spreads below.

Because we have default probabilities in addition to credit spreads, we can analyze the number of basis points of credit spread per basis point of default risk at each maturity.  This ratio of spread to default probability is shown in the following table for Wells Fargo & Company.  At all maturities, the reward from holding the bonds of Wells Fargo & Company, relative to the matched maturity default probability, is very high and roughly consistent with the levels found in our previous report.

The next graph plots the ratio of credit spread to default probability at each maturity. Again, we have added a smoothed line to the average spread to default probability ratio.

For Wells Fargo & Company, the spread to default probability ratios are very high across the board.  After some volatility at the shorter maturities, the reward for bearing a basis point of default risk declines from levels of over 40 times to ratios generally in the 10 to 20 times default risk range.

The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name.  For the week ended October 11, 2013 (the most recent week for which data is available), the credit default swap trading volume on Wells Fargo & Company showed 66 contracts trading with a notional principal of $599.2 million. This compares with only 6 contracts traded for a notional principal of $12 million in our last report.  For the 155 weeks ended June 28, 2013, the statistics for credit default swap trading on Wells Fargo & Company are shown here:

Compared to more than 1,000 other reference names, Wells Fargo & Company ranked 52nd in trading volume depicted in the following graph:

On a cumulative basis, the default probabilities for Wells Fargo & Company have increased slightly from our July report.  The current cumulative default probabilities, shown in green, range from 0.02% at 1 year to 0.96% at 10 years, up 0.05% from our July report.  Cumulative default probabilities as of July are shown in yellow.

Over the last 10 years, the 1 year and 5 year default probabilities for Wells Fargo & Company have varied as shown in the following graph. The one year default probability peaked at over 9.00% and the 5 year default probability peaked just short of 3.00% in the first half of 2009 after the Wells Fargo takeover of Wachovia. Wachovia’s peak borrowings from the Federal Reserve were $36.0 billion on October 6, 2008, four days before its acquisition by Wells Fargo became effective.  A Kamakura Corporation report documents these borrowings on a daily basis and the time line leading up to the Wells Fargo acquisition.

Over the same decade, the legacy credit ratings (those reported by credit rating agencies like McGraw-Hill (MHP) unit Standard & Poor’s and Moody’s (MCO)) for Wells Fargo & Company have changed five times.

The macro-economic factors driving the historical movements in the default probabilities of Wells Fargo & Company over the period from 1990 to the present include the following factors of those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:

• Unemployment
• 10 year U.S. Treasury yield
• BBB-rated corporate bond yields
• The Dow Jones Industrials stock price index
• Home price index
• Commercial real estate index
• 3 international macro factors

These macro factors explain 77.0% of the variation in the default probability of Wells Fargo & Company since 1990.

Wells Fargo & Company can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat.  For the USA banking sector, Wells Fargo & Company has the following percentile ranking for its default probabilities among its 643 peers at these maturities:

1 month	74th percentile, up 12 percentiles since July
1 years	31st percentile, up 13 percentiles since July
3 years	8th percentile, up 2 percentiles since July
5 years	6th percentile, unchanged
10 years	5th percentile, unchanged

The relatively high percentile ranking at 1 month continues.  It is due simply to the very good near-term prospects for the banking industry generally, with nearly all banking firms showing very low short term default risk.  Kamakura Corporation reported today that corporate credit conditions are at the 90^th percentile level.  A comparison of the legacy credit rating for Wells Fargo & Company with predicted ratings indicates that the company is overrated by two ratings grades.

Conclusions

Wells Fargo & Company, other than the period immediately after the acquisition of Wachovia, has experienced very strong default probability levels for the last decade. At a 10 year horizon, the firm is in the top 5 percent of the USA banking sector in credit quality.    At current default probability levels, we believe that almost all sophisticated analysts would rate Wells Fargo & Company as investment grade by the Comptroller of the Currency definition.  Wells Fargo & Company’s default probabilities on the short end of the maturity spectrum have ticked up slightly since our last report, and credit default swap trading volume has increased from near zero during the summer to a fairly average level for Wells Fargo & Company.  While this bears monitoring, the bonds of Wells Fargo & Company offer a superior reward to risk ratio relative to the other firms analyzed in this series of notes.

Background on Default Probabilities Used

The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.

General Background on Reduced Form Models

For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.