In this note we analyze the current levels and past history of default probabilities for Wells Fargo & Co. (NYSE:WFC). We compare those default probabilities to credit spreads on 400 bond trades in 25 different bond issues on July 17, 2013. 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. We find that Wells Fargo & Co. bonds offer a very attractive ratio of credit spread to default probability risk. We analyze the maturities where the credit spread/default probability ratio is highest for Wells Fargo & Co. We also consider whether or not a reasonable investor would judge the firm to be "investment grade" under the June 2012 rules mandated by the Dodd-Frank Act of 2010.
Definition of Investment Grade
On June 13, 2012, the Office of the Comptroller of the Currency published the final rules defining whether a security is "investment grade," in accordance with Section 939A of the Dodd-Frank Act of 2010. The new rules delete reference to legacy credit ratings and replace them with default probabilities. The web page explaining the Office of the Comptroller of the Currency's new rules defining investment grade and related guidance can be found here.
Term Structure of Default Probabilities
Maximizing the ratio of credit spread to match 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 & Co. ranging from one month to 10 years on an annualized basis. The default probabilities range from 0.02% at one month to 0.01% at 1 year and 0.09% at ten years.
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. TRACE data for Wells Fargo & Co. included 469 trades on the bonds of the firm on July 17, 2013. After eliminating obvious outliers, 400 trades were analyzed on 25 different bond issues.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Wells Fargo & Co. 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 & Co. 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 pm Wells Fargo & Co. 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 & Co. 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 & Co. 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 spreads 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.
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 & Co. At all maturities, the reward from holding the bonds of Wells Fargo & Co., relative to the matched maturity default probability, is very high.
The next graph plots the ratio of credit spread to default probability at each maturity.
For Wells Fargo & Co., the highest spread/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 50 times to ratios generally in the 10 to 30 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 July 12, 2013 (the most recent week for which data is available), the credit default swap trading volume on Wells Fargo & Co. showed 6 contracts trading with a notional principal of $12.9 million.
On a cumulative basis, the default probabilities for Wells Fargo & Co. range from 0.01% at 1 year to 0.91% at 10 years, as shown in the following graph.
Over the last 10 years, the 1 year and 5 year default probabilities for Wells Fargo & Co. 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 (NYSE:MHFI) unit Standard & Poor's and Moody's (NYSE:MCO)) for Wells Fargo & Co. have changed six times.
The macro-economic factors driving the historical movements in the default probabilities of Wells Fargo & Co. 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:
- 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 & Co. since 1990.
Wells Fargo & Co. can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the US banking sector, Wells Fargo & Co. has the following percentile ranking for its default probabilities among its peers at these maturities:
1 month 62nd percentile
1 year 18th percentile
3 years 6th percentile
5 years 6th percentile
10 years 5th percentile
The relatively high percentile ranking at 1 month 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. A comparison of the legacy credit rating for Wells Fargo & Co. with predicted ratings indicates that the company is overrated by two ratings grades.
Wells Fargo & Co., 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 US banking sector in credit quality. At current default probability levels, we believe that almost all sophisticated analysts would rate Wells Fargo & Co. as investment grade by the Comptroller of the Currency definition.
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.