Today marks the 20th anniversary of the founding of risk management firm Kamakura Corporation. In this blog we take a brief look at some of the biggest surprises in our first 20 years in the risk management business.
Surprise number 1. When I first announced that I was quitting my job to start my own risk management firm, I got tons of calls from former colleagues telling me what a risky and crazy thing I was about to attempt. The biggest surprise of the last 20 years is that my three former employers are all gone: Lehman Brothers, Security Pacific Corporation, and First Interstate Bancorp.
Surprise number 2. All three of my former employers failed for the same reason: over-exposure to commercial real estate. After watching the same drama unfold over and over again, I am still surprised that financial institutions are surprised by the risk in commercial real estate lending.
Surprise number 3. In 1990 I called my friend Oldrich Vasicek after reading an article in the American Banker. In the early days of Kamakura, we were working with Oldrich and his partner Gifford Fong on a number of projects. The American Banker article noted that Oldrich was involved in another firm called KMV which pioneered the use of quantitative default probabilities as an alternative to legacy ratings. After 5 years of working together, Kamakura decided to take a much different approach to risk assessment using the multiple models approach that includes both Merton-style models and the more modern reduced form technique pioneered by Kamakura’s director of research Professor Robert Jarrow. After 20 years of experience with quantitative default probabilities, I am surprised that so many people still pay attention to legacy rating agencies. They should have no more role in modern finance than a hand-held calculator does.
Surprise number 4. During the 20 year history of Kamakura, we’ve helped clients deal with wave after wave of new derivative products. In some cases, the new products provided enormous convenience, but in recent years the rationale for new products has been to confuse both buyers of the products and management of the originator’s institution into perceiving profit where in fact there was a loss. Surprise number 4 for me has been the lack of cynicism on the part of investors and management when Wall Street designs the next great Completely Dorky Obligation. If the complexity of the structure has no economic rationale, one shouldn’t buy it. As Lawrence McDonald (@convertbond on www.twitter.com) points out regularly, if you can’t find the sucker at the poker table, it’s probably you. Time to step away from the poker table.
Surprise number 5. By accident, I had the good fortune to have a front row seat to watch the bursting of the bubble in Japan. I arrived in Tokyo in 1987 at Lehman Brothers and watched with amazement as young bond traders rained 100 yen coins on taxi cab drivers who wouldn’t stop to pick them up. The Nikkei stock index peaked just short of 39,000 and was as low as 7,000 19 years later. Commercial real estate prices fell by 60 percent. Home prices fell 60% in the major cities and lenders who had been making 100% loan to value mortgages (“No American banker would be dumb enough to do that” I thought) got killed. Surprise number 5 was the overwhelming sense of many that it couldn’t happen ‘here’—that experience elsewhere was irrelevant to the United States. Another variation on this surprise is the sense of many that, if something had never happened during your own career or your own lifetime, it would never happen during your career or your lifetime.
Surprise number 6. For many many years, financial institutions have relied on models or risk systems whose inner workings were intentionally hidden from the user. This has been astonishing surprise number 6 for me. The same cynicism that should lead one to reject the Completely Dorky Obligation should lead one to another realization: if the maker of the system or the model doesn’t disclose how it works, it is because you wouldn’t like what you saw in that disclosure.
Surprise number 7. When regulators audit the bankers that use the black boxes in Surprise number 6, they haven’t given the bankers a failing grade. They simply avert their eyes. After two trillion dollar bailouts in the United States alone, this amazes me. “Why don’t you put a stop to the use of black box systems?” I asked one regulator. He simply replied “I’d like to but…” and he never finished the sentence. Amazing.
There have been many other surprises over the years, but the party is starting here and I have to bring this to a close. One of the wonderful things that has not surprised me over the years is the dedication, perseverance, and intelligence of my colleagues and clients that have made the last 20 years such a pleasure. I can never thank you enough.
Donald R. van Deventer
Honolulu, April 1, 2010