Telling Fortunes

A San Francisco firm rolls the dice in the multibillion-dollar game of global finance

But stock price is more than a measure of total worth. KMV considers it a telling indicator of a company's fate.

That's because the price of a company's stock is distilled from every conceivable force that comes to bear on financial markets. The perceptions of thousands of investors, the best guesses of hundreds of analysts, history, current events, the weather, and national and global politics meld into a single, all-encompassing number -- the stock price. That's why the Dow Jones Industrial Average jerks on every tidbit of financial news.

In effect, the price put on a "financial instrument" -- as economists call anything worth money -- is the result of a massive, ongoing opinion poll. And unlike a grocer's opinion expressed as the price on a head of lettuce, stock price is an opinion about a company's future. It expresses thousands of people's feelings about a company's potential risk, and potential return.

The KMV model presumes that you can take all available information about a company, beam it through an algorithmic prism, and shine a focused ray of light into the future.

According to KMV's model, for example, high-flying is in much better financial health than traditional ratings agencies such as Standard & Poor's believe. According to KMV, Amazon stands only a quarter of 1 percent possibility of default. Standard & Poor's, the most-watched rating agency, puts the likelihood of default at around twice that. Moody's, the other big rating agency, says Amazon's chances are even worse.

Even KMV Managing Director Tim Kasta is candidly astounded at what the market is saying about Internet companies.

"Amazon's a wild one," says Kasta. "We believe in the market, so I guess this is right, but this is amazing."

Still, he says, one banker he knows bought stock awhile ago based on KMV's optimistic assessment -- and made a killing.

KMV customers owe their new crystal ball to entrepreneurs John McQuown and Oldrich Vasicek, a pair of former Wells Fargo bankers who got the idea in the early 1980s that they could apply the Merton and Scholes financial theories to bond markets.

McQuown and Oldrich created KMV in its current form 10 years ago, just when computer technology was reaching a point where off-the-shelf machines could handle the massive amounts of data that make the KMV model work. The model now monitors around 20,000 companies in North America, Asia, and Europe by running publicly available financial data through top-secret algorithms developed by Vasicek.

"To develop these algorithms, Vasicek solved mathematical equations that had never been solved before," says Kasta, the KMV managing director.

These algorithms allow KMV to use past changes in a company's stock price to come up with a number predicting future changes. A company whose stock has swung vigorously in the past has the potential to dip perilously close to bankruptcy in the future.

Banks and other customers pay between $100,000 and $500,000 per year for the right to view computer screens displaying the sum results of KMV's data crunching. With a few mouse clicks, these bankers can pull up numbers describing the likelihood that General Motors will default on a particular day. A few more clicks produce the combined default probability of numerous Hong Kong companies, illuminating the health of the country as a whole.

The amount of data required to launch the KMV project 10 years ago was mind-boggling, McQuown says.

"We started in February 1989, but it wasn't until April 1991 that we had it up and running," McQuown says. "We had to process a lot of information in order to compete in this world. And in the background was the development of the personal computer -- that was just when the 80386 chip was introduced, and it was fast enough, and with enough storage capacity, that around $5,800 would get you a reasonable amount of computing power. You could load up a database, and all of a sudden, you could distribute information in a consistent, effective way."

Like any new product, selling the model to banks was difficult at first. Sales grew as computer analysis pervaded more and more areas of banking. During the last three years, a number of computer-risk-analysis competitors have entered KMV's field. In 1997, JP Morgan launched a similar risk-analysis program, as did Credit Suisse Financial Products. The British consultancy McKinsey & Co. is marketing a package called CreditPortfolioView, and another consultancy, KPMG, has a risk-measurement package of its own. According to Risk magazine, at least two more such products should be on the market by the end of this year. And many banks have in-house models that help them analyze their investment portfolios.

But KMV remains atop this heap by virtue of the massive amount of information its computer models crunch, the proprietary mathematics contained in its estimates, and the impressive track record of some of its predictions.

KMV's model foresaw Apple computer's improving financial health at the beginning of 1997, months before Standard & Poor's decided to make new, more optimistic projections about the quality of Apple debt. And the KMV model saw Zenith Corp. heading for its May 1998 default a year-and-a-half before Standard & Poor's sensed trouble.

Some investors have found the model similarly useful for divining the health of entire countries. While investors were unanimously caught off guard by the 1997 Asian meltdown, KMV's model had been chronicling a steady deterioration in credit value in countries like South Korea since 1994. Standard & Poor's, meanwhile, didn't downgrade Korea's sovereign debt until after November 1997, when Korea went to the International Monetary Fund begging for a rescue package.

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