CBA’s Sale of Life Insurance Business is Credit Positive

From Moody’s

Last Thursday, Commonwealth Bank of Australia announced that it had agreed to sell its Australian life insurance business, CommInsure Life,7 and its New Zealand life and health insurance businesses, Sovereign,8 to Hong Kong-based insurer AIA Group Limited for AUD3.8 billion ($3.0 billion). The transaction is credit positive for CBA because it will boost its capital adequacy. The deal also is credit positive for AIA because it will strengthen the insurer’s franchise and distribution in Australia and New Zealand with only a modest increase in financial leverage.

The sale price equals a price/book ratio of approximately 1.7x these businesses’ net tangible asset as of June 2017. The two companies also announced a 20-year bancassurance distribution agreements in both markets.

The announced sale comes at a time when mortgage risk weights and capital requirements are rising for Australian banks. In July 2017, the Australian Prudential Regulation Authority announced stricter capital requirements for Australian banks, including that Australia’s four largest banks, including CBA, raise their common equity Tier 1 (CET1) ratios to 10.5% by 1 January 2020.

These sales will put CBA in a strong position to meet this target. As of June 2017, CBA’s CET1 ratio was 10.1%. CBA estimates that the sale will release approximately AUD3 billion of CET1 capital, raising the bank’s fiscal 2017 (which ended 30 June 2017) CET1 ratio by approximately 70 basis points on a pro forma basis. The bank is currently dealing with allegations of non-compliance with Australia’s Anti-Money Laundering and Counter-Terrorism Financing Act that could result in a financial penalty that, depending on its size, could erode the bank’s capital position.

 

For AIA, the transaction will strengthen the insurer’s franchise and scale in Australia and New Zealand, where it will become those market’s largest life insurance provider. The 20-year bancassurance distribution agreements with CBA and ASB Bank Limited, which is CBA’s New Zealand subsidiary, will complement AIA’s distribution in these two markets, where AIA has traditionally focused on group business and the independent financial adviser channel.

AIA’s purchase will increase its financial leverage, although it will be small relative to its capitalization. The net cash outlay for the transaction will be only AUD2.1 billion ($1.7 billion), after taking into account reinsurance arrangements, and AIA’s strong capitalization should be able to easily absorb that amount. As of May 2017, AIA reported total equity attributable to shareholders of $38.3 billion and a solvency ratio of 427% at its main operating company, AIA Company Limited (financial strength Aa2 stable). AIA expects the transaction to be earnings accretive in the first year after deal completion.

From a strategic perspective, the transaction aligns AIA and CBA with their respective strengths in insurance product origination and distribution. AIA already has a strong track record in Australia and New Zealand and has strong capabilities in group-wide risk management, claims management and product development, resources on which it can leverage to further enhance its newly acquired businesses

Bond Returns, Lower For Longer?

From Moody’s

A less accommodative US monetary policy may heighten market volatility near term. However, over time, the fundamentals that give direction to business activity and financial markets will prevail. For now, current trends involving demography, technology, regulation, and globalization favor the containment of core price inflation and still relatively low US Treasury bond yields.

Because price deflation is anathema to both profit margins and credit quality, a low enough rate of price inflation will adversely affect both equity prices and systemic financial liquidity. If US core consumer price inflation (which excludes volatile food and energy prices) now eases amid a relatively low and declining unemployment rate, what might become of core consumer prices once unemployment inevitably rises? Today’s already sluggish rate of core consumer price growth increases the risk of outright price deflation if sales volumes endure a recessionary contraction.

US consumer price inflation lacks both the speed and breadth necessary for a lasting stay by a 10-year Treasury yield of at least 2.5%. Because the Fed’s preferred inflation measure — the PCE price index — can be temporarily buffeted about by wide swings in food and energy prices, our focus is on the core PCE price index, which best captures consumer price inflation’s underlying pace.

Pockets of price deflation warn against aggressive tightening

The annual rate of core PCE price index inflation was merely 1.4% in July. The accompanying -2.0% annual rate of consumer durables price deflation underscores the considerable risk of pushing too hard on the monetary brakes. Both persistent consumer durables price deflation and August 2017’s -0.9% annual rate of core consumer goods price deflation (as measured by the CPI) warn that too rapid a rise by interest rates risks even lower prices among businesses already burdened by a loss of pricing power. Prolonged core consumer goods price deflation might yet thin profit margins by enough to necessitate layoffs.

The CPI tells roughly the same story as the PCE price index, where inflation gives way to deflation outside of consumer services. By far the fastest price growth has been posted by consumer services, whose pricing benefits from the category’s relative immunity from global competition. For example, August 2017’s 1.7% annual rate of core CPI inflation consisted of a 2.5% annual rate of consumer service price inflation that differed considerably from the aforementioned -0.9% annual rate of core consumer goods price deflation. Core consumer goods price deflation has held in each month since March 2013 and it posted its worst reading since August 2004’s -1.2% in August 2017.

Moreover, consumer service price inflation has been skewed higher by the relatively rapid growth of shelter costs. After excluding August 2017’s 3.3% yearly increase by the CPI’s shelter cost component, the 1.7% annual rate of core CPI inflation drops to 0.5%, which was the slowest such rate since the 0.5% of January 2004.

Expectations of a 2% to 3% Return from Bonds May Become the Norm

Investment professionals now include expectations of a prolonged containment of price inflation in their long-term outlook for prospective returns. For example, a member of Vanguard Group’s global investment-strategy team reiterated Vanguard’s expectation of expected returns for the next decade of 5% to 8% for equities and 2% to 3% for bonds, according to Bloomberg News.

The expected 2% to 3% return from bonds during the next 10 years is at odds with both the FOMC’s median projection of a 2.75% federal funds rate over the long-term and consensus forecasts of a 3% to 3.5% average for the 10-year Treasury yield during the next 10 years.

The cited Vanguard investment manager claimed that bond yields will be reined in by low price inflation stemming from demographic change, globalization, and technological progress. Aging populations will weigh on household expenditures. An aging population implies less in the way of household formation that otherwise accelerates spending vis-a-vis income and, by doing so, imparts a powerful multiplier effect.

Furthermore, the US workforce now ages in tandem with the overall population. According to the Labor Department’s household survey of employment, the employment of Americans aged at least 55 years surged by a cumulative 31.2% since June 2009’s end to the Great Recession through August 2017. Because the latter was so much faster than the accompanying 9.6% increase by total household-survey employment, the number of employees aged at least 55 years rose to a record 23.2% of household survey employment in August. The unprecedented aging of both the US workforce and population will limit the upsides for household expenditures, core consumer price inflation, benchmark interest rates, corporate earnings growth, and corporate debt growth.

Globalization has weakened the tendency of a tighter US labor market to quicken wage growth and, thereby, stoke consumer price inflation. Globalization exposes US workers to the often cheaper and increasingly skilled workforces of dynamic emerging market countries. Heightened labor-market competition implies that employee compensation will be more closely aligned with a worker’s individual performance. Attractive across-the-board wage hikes are a thing of the past.

Meanwhile, technological progress will facilitate the production of higher quality products at lower costs. Thanks to technology, cost-push deflation may push aside cost-push inflation.

Faster price growth requires the sustenance of faster income growth

A recurring annual rate of consumer price inflation of at least 2% requires that consumers be able to afford such a steady and broadly distributed climb by prices. The atypically slow 2.6% annual rise by wage and salary income of the 12-months-ended July 2017 questions consumer spending’s ability to sustain consumer price inflation at 2% or higher. An improving trend has yet to materialize according to July’s merely 2.5% yearly increase by wages and salaries.

Never before has wage and salary income grown so slowly over a yearlong span more than three years into a business cycle upturn. Yes, it may be true that 2017’s deceleration by wages and salaries reflects an attempt to delay receiving employment income until after possible income tax cuts take effect, but most workers are incapable of timing the receipt of income. Thus, to the extent any slowing of 2017’s wage and salary income reflects a tax-driven postponement of such income, attention is brought to a distribution of income that may be increasingly skewed toward higher income individuals. If true, then any percent increase by wage and salary income will supply less of a boost to household expenditures
and business pricing power compared to the past.

Today’s dearth of personal savings and weakened financial state of America’s lower- and middle-income classes subtract from business pricing power. Less personal savings leaves consumers with less of a buffer with which to absorb widespread price hikes. When savings are low or practically nonexistent, affected consumers may react to broadly distributed price hikes by cutting back on real consumer spending, which, in turn, leads to an accumulation of unwanted inventories and remedial price discounting.

When the core PCE price index averaged a rapid annual advance of 6.6% during 1971-1981, the US personal savings rate averaged 11.6% of disposable personal income. By contrast, since the end of 1995, the 1.7% average annual rate of core PCE price index inflation has been joined by a much lower average personal savings rate of 5.0%, where the personal savings rate was an even skimpier 3.9% during the 12-months-ended July 2017. Moreover, to the degree the distribution of income has become increasingly skewed toward the top, the personal savings rate of middle- to lower-income consumers may now be noticeably lower.

The FOMC now believes that the annual rate of core PCE price index inflation will remain under 2%, but only through 2018. However, core PCE price index inflation is likely to average something less than 2% annually through 2027, especially if employee compensation cannot sustain a pace faster than 4% annually.

Blockchain Prototype Is Credit Positive for P&C Insurers and Reinsurers

The Blockchain Insurance Industry Initiative (B3i) has unveiled a prototype application that streamlines contracts between insurers and reinsurers using blockchain technology according to Moody’s. Once the technology becomes mainstream, they expect that it will significantly reduce policy management expenses and speed up claims settlement for insurers and reinsurers, a credit positive.

B3i’s application gives insurers, reinsurers and brokers a shared view of policy data and documentation in real time.

Blockchain’s shared digital ledger has the potential to increase the speed and reduce the friction costs of reinsurance contract placements. Reinsurers would use the common platform to streamline claims analysis, potentially reducing significantly their administration and management costs.

Blockchain technology is a chain of blocks of encrypted data that form an append-only database of transactions. Each block contains a record of transactions among multiple parties, each of which has real-time access to a shared database. As a block is encrypted with a link to the previous block, it cannot be altered, except by unencrypting and amending all subsequent blocks.

PricewaterhouseCoopers estimates that blockchain technology will reduce reinsurer non-commission expenses by 15%-25%, including data processing efficiencies and reduced chance of overpayment because of data errors. For illustrative purposes, the exhibit below shows the potential effect on annual pre-tax earnings for some of the world’s top reinsurance companies, all of which are included in the B3i consortium. We also expect the technology to decrease the time between primary insurance claim and reinsurance reimbursement, a credit positive for primary insurers.

B3i launched in October 2016 with five original members, including Aegon N.V., Allianz SE, Munich Reinsurance Company, Swiss Reinsurance Company Ltd. and Zurich Insurance Company Ltd. It now has 15 members. Beta testing for B3i’s program is scheduled for October and is open to any insurers, reinsurers or brokers that wish to pilot the technology, regardless of their membership status in the consortium. Although the initial pilot was for property-catastrophe excess-of-loss policies, B3i plans to broaden its application to other types of reinsurance, catastrophe bonds and other insurance- linked securities.

S&P 500 Reaches New Heights (Again)

The US index has reached another high and a 5-year view highlights the strong growth, and momentum since Trump won the election last year.

So, what are the expectations ahead? Well, according to a piece from Moody’s:

An overvalued equity market and an extraordinarily low VIX index offer no assurance of impending doom for US equities. Provided that interest rates do not rocket higher, expectations of corporate earnings growth should be sufficient for the purpose of avoiding a severe equity market correction that would doubtless include the return of corporate bond yield spreads in excess of 700 bp for high yield and above 200 bp for Ba a-rated issues.

For now, the good news is that early September’s Blue Chip consensus expects core profits, or pretax profits from current production, to grow by 4.4% in 2017 and by 4.5% in 2018. Moreover, earnings-sensitive securities should be able to shoulder the 2.5% 10-year Treasury yield projected for 2017’s final quarter. However, the realization of a projected Q4-2018 average of 3.0% for the 10-year Treasury yield could materially reduce US share prices.

Since 1982, there have been seven episodes when the month-long average of the market value of US common stock sank by at least -10% from its then record high. Only two of the seven were not accompanied by at least a -5% drop by core profits’ moving yearlong average from its then record high.

In conclusion, the rich valuation of today’s US equity market very much warns of at least a -10% drop in the market value of US common stock in response to either unexpectedly high interest rates or a contraction of profits. Perhaps, the prudent investor should be braced for at least a -20% plunge in the value of a well-diversified portfolio at some point during the next 18 months.

Genworth Under Ratings Agency Scrutiny

Genworth, the listed Lenders Mortgage Insurer updated the ASX yesterday of the results of the outcomes of recent rating agency reviews. The ratings agencies appear somewhat split on how to assess the risks in the sector.

Fitch ratings affirmed the A+ IFSR and maintained the outlook at stable – saying Genworth had a robust standalone credit profile, solid operating performance, strong capital ratios and conservative investment approach. They noted a generally stable operating environment which continues to support the performance of the insurance portfolio.

Standard & Poor’s rating affirmed the A+ IFSR and maintained the outlook at negative noting standalone credit profile, business risk profile and strong capital and earnings position. “Claims paying resources, which include conservatively invested capital, claims reserves and external reinsurance are supportive of the company’s ability to absorb a significant level of claims if Australia were to experience a severe extended economic downturn”.

Moody’s has however revised its unsolicited IFSR on GFM1 from A3 with a negative outlook to Baa1 with stable outlook. This follows Moody’s wider rating action on financial institutions in June 2017 to reflect its view that “risks in the Australian housing market have risen, heightening the financial sector’s sensitivity to adverse shocks”.

So, you “pays your money and takes your choice!”

A very low VIX Index weighs against a higher bond default rate

From Moody’s.

The state of the US equity market also helps to give direction to the bond default rate. A well-functioning equity market helps to assure ample liquidity. In the extreme case of infinite liquidity, defaults would be nonexistent.

To the degree business assets are attractively priced, financially-stressed firms will find it easier to obtain relief via injections of common equity capital. For example, firms can secure more cash through the divestment of business assets when equity markets thrive.

Thus, the record shows that the moving 12-month average of the VIX index tends to lead the high-yield default rate. Recently, the VIX index’s moving 12-month average sank to a record low 12.2 points.

As inferred from their long-term statistical relationship, if the VIX index’s yearlong average remains under 13.25 points, the default rate is likely to dip under 2%. It may be premature to consider the possibility of a rising default rate until the VIX index’s unprecedented slide is reversed.

Low US Inflation Signals Interest Rates Will Remain Lower For Longer

The latest data from the US which shows low inflation and wage growth has pulled the implied forward interest rates down suggesting the Fed will hold rates lower for longer.  This is reflected in falling yields on the T10.

Nearly half of the “Trump Effect” repricing has been undone.

This is also flowing into lower rates in the international capital markets, which is translating to lower costs of funds for the Australian banks (one reason why Westpac has cut their fixed rates).

As a result, in our default model, we have reduced the likelihood of an interest rate rise for mortgage holders in Australia over the next few months. This will translate to a projected fall in defaults, despite rising mortgage stress. We will publish the August data on Monday.  Households are likely to be able to muddle through and the RBA will hope business investment, which was stronger this time, works through.

Meantime, here is interesting commentary from Moody’s on the US, who highlight that the latest drop by personal savings in the US brings attention to the financial stress now facing many households there.

The recent slowdown by the underlying rate of consumer price inflation significantly lowered the risk of a disruptive climb by interest rates. In response, the VIX index sank from the 16.0 points of August 10, 2017 to a recent 10.7 points, while a composite high-yield bond spread narrowed from August 11’s 410 bp to August 30’s 399 bp.

However, the narrowing by the high-yield bond spread has been limited by a climb by the average high yield EDF (expected default frequency) metric from the July 2017 average of 3.9% to the 4.4% average of the five-days-ended August 30. Moreover, the US high-yield credit rating revisions of the third-quarter todate show downgrades topping upgrades even after excluding rating changes that were not primarily driven by fundamentals.

As recently as early July 2017, the Blue Chip consensus had anticipated a 2.5% average for Q3-2017’s 10-year Treasury yield. Much to the contrary, the 10-year Treasury yield has averaged 2.26% thus far in the third quarter, including a recent 2.13%. Not even a widely anticipated September 2017 start to the Fed’s reduced reinvestment of maturing bonds has been capable of lifting Treasury bond yields demonstrably.

In addition to July’s 1.4% annual rate of core PCE price index inflation, benchmark bond yields have been reined in by the market’s much reduced expectation of another Fed rate hike for 2017. As of mid-day on August 31, the futures market implicitly assigned only a 36.4% likelihood to fed funds’ midpoint finishing 2017 at something greater than its current 1.125% according to the CME Group’s FedWatch tool.

By itself, core PCE price index inflation’s performance of the last 20 years suggests that the FOMC may have considerable difficulty as far as sustaining PCE price index inflation at 2% or higher. For the 20-years-ended June 2017, core PCE price index inflation averaged only 1.7% annually. The annual rate of core PCE price index inflation was at least 2% in only 58, or 24.2%, of the last 240 months (20 years).

For those months showing an annual rate of core PCE price index inflation of at least 2%, the average annual rate of core inflation was only 2.2%, wherein the fastest annual rate of core inflation was the 2.5% of August 2006.

Drop by personal savings curbs core inflation

The slower growth of wage and salary income has helped to contain price inflation. After decelerating from 2014’s 5.6% and 2015’s 5.5% to 2016’s 3.0%, the annual increase of private-sector wages and salaries approximated a still sluggish 3.1% during January-July 2017. In response to the pronounced slowdown by wages and salaries, personal savings have shrunk by -29% annually thus far in 2017 following yearlong 2016’s -18% plunge.

The drop by the ratio of personal savings to disposable personal income from its 6.1% average of the five years ended 2015 to the 3.8% of 2017 to date implies Americans lack the financial wherewithal to either support or absorb significantly higher prices for long.

High rates of personal savings make it easier for consumers to absorb higher prices. When core PCE price index inflation averaged 6.4% during 1970-1981, the personal savings rate averaged 11.7%. By contrast, the averages for January-July 2017 showed a much lower 3.8% personal savings rate and a much slower 1.6% annual rate of core PCE price index inflation.

In addition, the latest drop by personal savings brings attention to the financial stress now facing many US households. Today’s more unequal distribution of income implies that a relatively greater number of today’s households save little, if any, of their after-tax income. When confronted with higher prices, these “paycheck-to-paycheck” consumers will be compelled to eventually curtail real spending at the expense of business pricing power.

Regulator’s Inquiry of Commonwealth Bank of Australia’s Culture and Practices Is Credit Negative

From Moody’s

On Monday, the Australian Prudential Regulation Authority (APRA) announced that it would establish an independent prudential inquiry into the governance, culture and accountability framework of Commonwealth Bank of Australia (CBA, Aa3/Aa3 stable, a26). APRA’s focus on CBA’s culture and practices is credit negative and could damage the bank’s reputation as well as compel it to incur costs and use resources to address any mandated remedial actions.

APRA has stated that it will make the findings of its review public and that the inquiry will take around six months from its formal commencement. APRA’s regulatory review is the latest of several regulatory issues for CBA. On 3 August, the Australian Transaction Reports and Analysis Centre (AUSTRAC) commenced proceedings against CBA for non-compliance of the Anti-Money Laundering and Counter-Terrorism Financing Act. AUSTRAC alleges that CBA did not carry out a specific assessment of the money laundering and terrorism financing risk of intelligent deposit machines until three years after their introduction, and inadequately monitored and reported suspicious transactions.

We expect more information about the timing of AUSTRAC’s proceedings at the first case-management hearing scheduled on 4 September. We also expect CBA to file a statement of defense. CBA also faces a potential class-action lawsuit from shareholders that allege the bank did not meet its continuous disclosure obligations in relation to the AUSTRAC allegations. The Australian Securities and Investments Commission (ASIC) also has announced that it will investigate whether CBA did not meet these obligations.

In recent years, CBA has dealt with a number of conduct-related issues that have negatively affected the bank’s reputation. In August, ASIC announced that CBA would refund more than 65,000 customers approximately AUD10 million, after selling them unsuitable consumer credit insurance. In March 2016, the bank’s life insurance business, CommInsure, was accused of deliberately avoiding or delaying paying claims to its customers, but in March 2017, ASIC cleared CommInsure of any breaches of the law. However, ASIC identified areas that CBA should improve, which CBA has already done or is committed to doing. Also, CBA in 2014 announced an Open Advice Review program relating to the poor quality of advice and compliance breaches by its financial planning businesses, Commonwealth Financial Planning and Financial Wisdom.

Operational and compliance problems of this nature highlight the challenges of maintaining tight controls at large and complex institutions that span multiple business lines such as retail, commercial and institutional banking, insurance and wealth management. We note that the strong profitability of Australia’s major banks’ domestic franchises and the low credit costs amid an extended period of unusually low interest rates elevates the risk that banks become complacent in the their approach to operational and governance risks.

US Firms Coy About Borrowing More

From Moody’s

Comparatively thin high-yield bond spreads complement an increased willingness by banks to supply credit to businesses. The increased willingness to make business loans owes much to a benign outlook for defaults.

According to the Fed’s latest survey of senior bank loan officers, the net percent of banks tightening business — or commercial & industrial (C&I) — loan standards dipped from the +2.2 percentage point average of the four-quarters-ending with Q2- 2017 to the -3.9 points of Q3-2017. Moreover, the net percent of banks widening interest-rate spreads on new business loans plunged from the -7.9 percentage point average of the year-ended Q2-2017 to Q3-2017’s -21.1 points.

Though banks are more willing to lend to businesses, the business sector’s demand for C&I loans has receded. The same Fed survey of senior bank loan officers also found that the net percent of banks reporting a stronger demand for C&I loans from business customers sank from the -2.1 percentage-point average of the year-ended June 2017 to Q3-2017’s -11.8 points, which was the lowest quarter-long score since Q4-2011’s -15.7 points. However, Q4-2011’s reading followed a string of strong results as shown by the +14.9-point average of yearlong 2011.

By contrast, as of Q3-2017, the yearlong average of the net percent of banks reporting a stronger demand for C&I loans from business customers dropped to -6.2 points for its lowest such average since the -9.5 points of yearlong 2010. (Figure 3.)

Business borrowing says cycle upturn is past its prime

It is worth noting how the latest slide by the business-sector’s demand for C&I loans has occurred more than four years following a recession. In the context of a mature business cycle upturn, the yearlong average of the net percent of banks reporting a stronger demand for C&I loans previously sank to the -6.2 points of the span-ended Q3-2017 in Q2-2007 and Q4-2000.

Recessions materialized within 12 months of the previous two comparable drops by the business sector’s demand for bank credit. Granted the US may stay clear of a recession well into 2018, but the reality is that the current business cycle upturn is showing signs of age. Thus, the upside for interest rates is limited, especially if the annual, or year-to-year, rate of core PCE price index inflation stays under 2%. (Figure 4.)

A pronounced slowing by the annual growth rate of outstanding bank C&I loans from Q2-2016’s 10.2% surge to Q2-2017’s 2.2% rise is in keeping with a softer demand for C&I loans by business borrowers. However, the pace of newly rated bank loan programs from high-yield issuers tells a much different story.

After surging by 140.2% in Q1-2017 from Q1-2016’s depressed pace, the annual increase of new high-yield bank loan programs slowed to 2.1% in Q2-2017. Nonetheless, recent activity suggests the year-over-year growth rate for new high-yield bank loan programs will accelerate to roughly 16% during 2017’s third quarter. Support for this view comes from July 2017’s $52.4 billion of new bank loan programs from high-yield issuers that more than doubled the $24.1 billion of July 2016.

Lately, the growth of high-yield bank loan programs has been powered by refinancings of outstanding debt and the funding of acquisitions. Today’s relative ease of refinancing outstanding debt at easier terms highlights ample systemic liquidity, which will help suppress the incidence of default. Abundant liquidity also facilitates the take-over of weaker, default prone businesses by financially stronger entities. (Figure 5.)

Wells Fargo’s Auto Insurance Practices

From Moody’s

Last Thursday, Wells Fargo & Company announced an $80 million remediation plan for auto loan customers that it had incorrectly charged for collateral protection insurance (CPI) between 2012 and 2017. The announcement is credit negative for Wells Fargo. The remediation costs are relatively immaterial at approximately 1% of its pre-tax quarterly earnings, but the announcement is yet another negative reputational headline for the bank. Despite the limited financial effect, we expect that the announcement will exacerbate the damage to Wells Fargo’s reputation in this past year.

Wells Fargo requires auto loan customers to maintain comprehensive and collision insurance for financed autos during the term of the loan. The bank’s CPI program purchased auto insurance on the customer’s behalf from a third party if proof of auto insurance had not been provided. Wells Fargo’s review of its CPI program and related third-party vendor practices, which began in July 2016 and was prompted by customer concerns, found that approximately 570,000 customers may have been negatively and incorrectly affected.

Roughly 490,000 customers were incorrectly charged for CPI despite having satisfactory auto insurance of their own. Approximately 60,000 customers did not receive adequate notification and disclosure information from the vendor before the bank’s purchase of CPI on their behalf. Finally, for 20,000 customers, the required payments for the incorrectly placed CPI may have contributed to the default of their loan and repossession of their vehicle. Wells Fargo’s $80 million remediation plan intends to rectify financial harm to these customers. As a result of its initial findings, Wells Fargo discontinued its CPI program in September 2016.

Wells Fargo historically had strong customer satisfaction scores and a reputation for sound risk management. In September 2016, its lead bank subsidiary agreed to pay $185 million to federal regulators and the Office of the Los Angeles, California, City Attorney to settle sales practice issues. The settlement revealed that Wells Fargo’s retail banking incentive structure had led to pervasive inappropriate sales practices. The fallout from revealing the sales practices deficiencies resulted in a hit to Wells Fargo’s customer loyalty measure, shown in the exhibit below. Although the metric has improved from its fourthquarter 2016 low, the latest announcement could add pressure. However, on the positive side, there has been no significant sign of client attrition, despite the negative effect on customer loyalty metrics.

Furthermore, any resulting regulatory investigations, lawsuits or political inquiries could add to the bank’s costs, particularly for litigation. In particular, we have previously noted that the high end of Wells Fargo’s range for reasonably possible potential litigation losses in excess of its established liability was $2.0 billion at the end of the first quarter, up from $1.8 billion at year-end 2016 and $1.3 billion at year-end 2015. On the bank’s second-quarter earnings call, before this announcement, management indicated the high end of this range could grow by another $1.3 billion. Although these potential litigation costs are manageable given Wells Fargo’s robust pre-tax earnings, this recent announcement adds to profitability challenges the bank continues to face.