The 30 largest bank holding companies are submitting their Comprehensive Capital Analysis and Review 2014 stress tests to the Federal Reserve as this analysis is being written. The major banks in the United States are spending tens of millions of dollars to analyze the banks' ability to avoid default over 13 quarters and three scenarios for 28 macro-economic factors specified by the Federal Reserve. There is an alternative way to compare the capital strength of major U.S. financial institutions that avoids the well-known problems of legacy credit ratings and the highly concentrated trading in credit default swaps, 75% of which is among dealers and 87% of which is concentrated at a five year maturity. A superior alternative is to use traded bond prices of the major U.S. banks in order to extract a market view of the capital adequacy of the banks. In this Kamakura Corporation analysis, we do exactly that to compare the capital strength of Bank of America Corporation (BAC), Citigroup Inc. (C), and JPMorgan Chase & Co. (JPM).
This analysis uses 944 trades in 113 non-call fixed rate bonds with a principal amount of $ 303.7 million for Bank of America Corporation. For Citigroup Inc., we analyze 600 trades in 52 non-call fixed rate bonds with a principal amount of $ 261.2 million. Finally we use 574 trades in 43 non-call fixed rate bonds with a principal amount of $ 261.0 million for JPMorgan Chase & Co. All trades took place on January 7, 2014. Bonds for which a high credit spread of more than 300 basis points was reported were excluded from the analysis on the belief that such data was erroneous. This analysis differs from the CCAR 2014 stress testing process in a number of important dimensions:
- The market risk assessment is based on investments of $825.7 million by institutional investors. The bankers doing the CCAR 2014 analysis have somewhat less at stake.
- The market risk assessment is predominately an arms-length assessment, while the banks' CCAR 2014 analysis is a self-assessment with the same potential concerns associated with the self-assessment published annually by legacy rating agencies.
- The market risk assessment is based on all possible scenarios, not just the 3 CCAR 2014 scenarios
- The market risk assessment includes all maturities out to 2042 (the shortest maturity of the long bonds traded for each bank is February 7, 2042), while the CCAR analysis is available for 13 quarters.
- The market risk assessment is completely transparent, as the traded bond prices are public information
- The market risk assessment is "model independent," as no explicity default probability models or parameter assumptions are made as part of the analysis.
Calculation of Credit Spreads
The underlying U.S. Treasury yields used to calculate credit spreads are taken from the Federal Reserve H15 statistical release and interpolated by Kamakura Corporation to match the exact maturity date of each bond. This matched maturity U.S. Treasury yield is subtraced from the high, low and trade-weighted average yield for each bond on January 7, 2014. To get a term structure of credit spreads, Kamakura Corporation fitted a trade-weighted cubic polynomial to the weighted average credit spread on each bond. Of course a separate function was fitted for each of the three bank holding companies. The Bank of America Corporation fitted credit spread function explained 79.5% of the variation in credit spreads over the term structure. The Citigroup Inc. credit spread function explained 81.0% of the variation of Citigroup spreads. Finally, the JPMorgan Chase credit spread function explained 86.6% of the variation of credit spreads for the bank. The functions do not explain 100% of credit spread variation because the TRACE bond price detail includes both institutional and retail trades with a wide range in trade sizes.
We now turn to the market risk assessment of the three banks.
The Market Risk Assessment of
Bank of America, Citigroup and JPMorgan Chase
The graph below shows the fitted credit spread curves for the three bank holding companies from very short maturities out to almost 30 years. JPMorgan Chase & Co. credit spreads (the orange dots) are consistently lower than the credit spreads for Bank of America (the green dots) and Citigroup (the red dots) with the exception of the 5.875% Bank of America bonds due February 7, 2042. The low spreads on this Bank of America bond are not due to call provisions, because the term sheet states clearly that the bonds are not callable. For maturities out to 10 years, the market assessment assigns lower risk to Citigroup (because credit spreads are lower) than Bank of America. Beyond the ten year point, Bank of America credit spreads are below Citicorp credit spreads, and the differential widens considerably as the time horizon lengthens.
The market assessment of the three banks is clear: JPMorgan Chase is perceived as the least risky of the three banks with the exception of one observation in 2042. Citigroup is perceived as less risky than Bank of America for 10 years and under, but the ranking reverses at longer maturities. Bank of America, beyond ten years, is perceived as less risky than Citigroup and the risk differential gets wider as maturities approach 30 years.
Individual Bank Summaries
In the remainder of this analysis, we summarize the underlying data used to reach the conclusions above.
Bank of America
The graph below summarizes the high, low, trade-weighted average, and fitted credit spreads for all fixed rate non-call bond issues that traded for Bank of America on January 7, 2014. Any issues for which the reported credit spread is more than 3.00% are excluded.
There were 113 bonds of Bank of America Corporation for which traded prices were reported. Along with the credit spreads, we report the matched maturity Kamakura Risk Information Services default probabilities and the ratio of credit spread to default probability on each bond, as explained in this recent analysis of Bank of America.
The graph below charts the high, low, trade-weighted average and fitted credit spreads for Citigroup Inc. using 52 fixed rate non-call bond issues.
The spreads for all 52 bond issues for Citigroup, Inc. are reported below, along with matched maturity default probabilities and the credit spread to default probability ratios. For more details, see the recent Kamakura Corporation analysis of Citigroup bond risks and returns.
JPMorgan Chase & Co.
The next chart graphs the credit spread analysis using 43 bond issues of JPMorgan Chase & Co.
The chart below reports on the credit spreads, default probabilities, and reward-to-risk ratios for each bond.
The final sections of this report summarize information about the default probabilities used and the nature of the term "investment grade" in light of the changes required under the Dodd-Frank Act of 2010. Please see the studies of Bank of America and Citigroup mentioned above for the Kamakura Corporation analysis of their "investment grade" status.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on Seeking Alpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.
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.
Background on the Dodd-Frank Act and the Meaning of "Investment Grade"
Section 939A of the Dodd-Frank Act 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 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.
REPORT.-Upon conclusion of the review required under subsection , each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection .
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."
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in this article.