Telling Fortunes

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

As more and more financiers turn to models like KMV's, the world just might become a safer place, argues KMV Chairman John McQuown.

The risky 21st century described by Michel Camdessus could be over nearly as soon as it begins. Rather than living in a brave new world fraught with financial risk, we would inhabit a planet where investors really knew what they were getting into when they bought, say, the debt of a Korean shipbuilder. Financial bubbles based on economic folly would be less likely, and investors might be forewarned of financial collapses.

"There used to be no commonly shared frame for estimating default risk," McQuown says. "With the enormous proliferation of companies around the world, people are ready to invest money anywhere. But they need to better understand risk."

They need to have been able to predict, for example, that on Thursday, Jan. 14, Francisco "Chico" Lopes would become Brazil's finance minister following the abrupt resignation of his predecessor, Gustavo Franco, throwing the world into financial turmoil.

They need to peer into the future and predict on what date investors will begin changing their minds about the Silicon Valley miracle. They need to know when living-room investors will start moving their mouses to the "sell" icon. They need to know ahead of time when, or if, our San Francisco dance of millions will end.

But they can't, really. All risk assessment, including computer models, can never be anything more than reading the entrails of history.

Predicting events in the 21st-century financial world by studying events of the 20th isn't possible. Capital moves about the globe like a schizophrenic jet stream. We can measure with absolute accuracy every degree of temperature and every drop of rain that falls for a thousand years, and still not say with 100 percent certainty what the weather will be tomorrow. Or when the sky will fall.

But history's all we've got, and it can be telling. Take KMV's history, for instance.

Eight years before they got KMV up and running in 1991, McQuown and Vasicek made an early stab at convincing bankers to buy into their ideas about quantifying default risk. They pooled $10 million from venture capitalists, and went door to door trying to convince banks to sell them especially risky corporate loans at a cut rate. The plan was to resell the loans to other banks with more stomach for risk.

But McQuown and Vasicek were ahead of their time. Banks weren't interested in selling and buying risky loans. There was trouble with the model, too. Affordable computers didn't exist that could process the amounts of data Vasicek and McQuown needed to evaluate the corporate loans. Instead the pair worked with boxes and boxes of data printouts, crunching numbers on companies individually, without a quick way to cross-reference or compile company data the way KMV's model does now.

As it turned out, their business model involved trying to buy loans nobody wanted to sell, analyzing the data with a model that didn't work as well as it needed to, then trying to sell loans nobody wanted to buy.

"Everything that could go wrong, did go wrong," McQuown recalls.
Within a couple of years, they had burned through their $10 million of venture capital.

They went bankrupt.
They defaulted.
They suffered a financial collapse.

But in 1989 they picked up the pieces, refined the model, and found there was more money to be made assaying risks for others than taking risks themselves.

Now billions of dollars are moving across global borders based, in small part, on the prognostications of a group of failed investors with the fanciest rainmaking machine on the market.

Who could have predicted that?

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