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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Blog

May 12

Written by: Donald van Deventer
5/12/2009 6:58 AM 

In our April 16 blog post, we published the statement of Frank Partnoy to the SEC Roundtable on Oversight of the Rating Agencies.  As Frank says in his statement, it's obvious that the agencies have not met a reasonable accuracy standard for either structured products ratings or corporate ratings.  My post with Robert Jarrow on April 6, "Ratings Chernobyl," lists some of the problems that have arisen on the corporate side.  As Frank states in his SEC comments, now it's time to move forward and to remove ratings and the rating agencies from rules, regulations and investment policies.  Many clients ask, "How can we write an investment policy that doesn't refer to ratings?"  The answer is easy--exactly such a model investment policy is the subject of today's post.  Many thanks to Martin Zorn, H. Walter Young, and G. McKenzie on an early draft of this sample policy.  I alone am responsible for any errors th

ABC Company Investment Policy


The Risk and Investment Committee of ABC Company has adopted this investment policy in response to an analysis of the losses stemming from the credit crisis of 2007-2009.  These losses were clearly attributable to a number of factors that are likely to reoccur in the future.  This revised investment policy is designed to insure that, when similar circumstances come about, ABC Company does not repeat the mistakes of other investors in the past.  In the view of the Risk and Investment Committee, these factors were the primary causes of losses in the 2007-2009 credit crisis:

  • Failure of investors to independently assess the risks and valuation of investment products
  • Failure of investors to analyze structured products from the bottom up, a loan by loan and transaction by transaction valuation of structured products collateral and the implications of that collateral for valuation and risk
  • Failure to understand that complexity in product design is an intentional effort by investment banks and other product structurers to induce investors to overpay for a complex security that they are unable to value correctly
  • Reliance on third party ratings instead of independent valuation and risk assessment
  • Reliance on third parties with a conflict of interest, likely traditional rating agencies and investment banking firms
  • Failure to measure the sensitivity of each investment and the entire portfolio to changes in macro-economic factors like home prices, oil prices, commercial real estate prices, commodity prices, stock index levels, interest rates and foreign exchange rates
  • Failure to measure the correlated risk of the investment portfolio and the revenue, cash-flow and profitability of the firm’s operating businesses, due to common dependence on the same macro-economic factors
  • Failure to establish and monitor compliance with portfolio wide exposure to these macro economic factors
  • Failure to consider illiquidity of markets and the link between illiquidity and macro-factors
  • Failure to consider extension risk and other unintended consequences from embedded options

The purpose of this revised investment policy is to insure that ABC Company makes safe and sound investments and avoids these errors of others.

Objectives of the Investment Portfolio

The investment portfolio at ABC Company has been created and is managed to achieve the following objectives:

  • To insure that the credit risk of ABC Company remains within the limits set by the Board of Directors
  • To insure that ABC Company can meet its obligations to repay liabilities and pay operating expenses like salary, occupancy expenses, materials costs, and so on in a timely manner
  • To insure that the macro-economic risk embedded in the Company’s main operating business remains within the limits set by the Board of Directors

To the extent that it is not possible to meet these objectives, the Chief Investment Officer shall immediately notify the Chief Executive Officer, the Chairman of the Board of Directors, and the Chairman of the Audit Committee of the Board of Directors immediately by telephone and in writing.

Prohibited Investments

The following types of investments are prohibited under all circumstances:

  • Structured products where the underlying collateral is not fully disclosed on a transaction by transaction basis on demand, by the investor, in electronic form.
  • Structured products where the security is tranched by any criteria other than the maturity of interest and principal. Specifically, collateralized debt obligations or any security by any other name where tranches are created by the percentile rank of credit losses are prohibited
  • Structured products which are complex with no fundamental economic rationale for the complexity, such as CDOs and knock-in knock-out options on any instrument, are prohibited.  Other examples include first to default swaps, inverse floaters, and so on.
  • Securities of any kind if ABC company risk management department and investment department, or either department individually, are unable to perform an independent assessment of the valuation and risk sensitivity of the instrument
  • Instruments that contain embedded options that cannot be valued or modeled.
  • Any other securities that do not meet the investment criteria below

Investment Criteria

Securities whose purchase would be otherwise be allowable under the portfolio risk policies described below must, in addition, meet the following criteria in order to be acceptable for purchase:

  • The best available estimate of the probability of default on the instrument at the time of purchase must be no more than x.xx%
  • The best available estimate of the probability that the default probability on the instrument will reach a level of x.xx% during the life of the security must be less than 0.10% on an annualized basis
  • If ABC company is unable to evaluate the two probabilities above, purchase of the security is prohibited
  • Assessment of these probabilities should be based neither on information from investment banking firms nor on ratings or other information from rating agencies paid by the issuer or the structurer of the security

Portfolio Risk Limits

Even if a security meets the requirements set forth in the prior section, purchase of the security is prohibited if the security, on a pro forma basis, would fail to meet the following portfolio risk limits:

  • Definition of Portfolio: The portfolio for purposes of this investment policy includes not only securities and other investments but also the net present value of liabilities which must be paid from the returns on the portfolio plus the net present value of any other cash flows into or out of the portfolio which are driven by market forces.
  • Macro factor limits:  The sensitivity of portfolio value with respect to macro economic factors like home prices, commercial real estate prices, stock indices, commodity prices, interest rates, foreign exchange rates, and economic conditions shall be measured daily and monitored to insure that these sensitivities are within limits approved by the Board of Directors.  The Board of Directors shall review these risk limits no less frequently than annually.  If the Board fails to review the risk limits on a timely basis, no securities shall be purchased except U.S. Treasury bills of 100 days maturity or less until the risk limit has been reconfirmed by the Board.  Macro factor sensitivities will take into account the impact of macro factors have on counterparty and collateral default probabilities, credit spreads, bid-offered spreads, and the supply of funds to ABC Company
  • Currency limits: Only securities denominated in currencies approved by the Board of Directors are eligible for inclusion in the portfolio
  • Issuer limits: Only issuers approved by the Risk and Investment Committee may be included in the portfolio
  • Industry and Geographical Diversification Limits: The Risk and Investment Committee may impose limits on exposure by industry and geography, but these limits are in addition to, not a replacement for, the macro factor limits described above
  • Instrument Diversification: the policy should recognize that sub-markets react differently to macro-economic conditions and product limits should be established based upon the objectives of the portfolio and the economic sensitivity of the firm’s operating businesses, if applicable
  • Probability of Failure Limits: The best available estimate of the probability that ABC Company goes bankrupt or is otherwise unable to make timely payment of interest, principal, salaries, rents, etc. shall be no more than 0.05% on an annual basis over a period no shorter than the longest maturity security or liability in the portfolio
  • Market Probability of Failure Limits: The portfolio will be managed in such a way that observable quotations of credit default swaps on ABC shall be no more than z.zz%

Monitoring and Reporting of the Investment Policy

Performance of the portfolio with respect to these limits should be monitored daily and reported to the Risk and Investment Committee on a weekly basis.  Any violations of these policies will be reported immediately by telephone and in writing to the Chief Executive Officer, the Chairman of the Board of Directors, the head of the Audit Committee of the Board, and the Senior Partner responsible for the external audit of ABC Company

Donald R. van Deventer
Kamakura Corporation
Honolulu, May 12, 2009