How to Expect the Unexpected Before the Competition

Although complex in detail, market and credit risk are, by definition, simple, said Sean Kelley, ’06, portfolio analyst for Tall Tree Investment Management, LLC. “Risk is the unexpected,” Kelley told the Weekend and Evening Investment Management Group at Gleacher Center on August 16.

“You can distill the job description of a risk manager down to one line: I analyze my credit, portfolio, whatever you have, so I can expect the unexpected before the guy next to me expects it,” he said. “At some point in your career in the credit business, you will loan money to a company that defaults.”

To minimize the frequency of those defaults, Kelley recommends a four-part strategy. “First, understand the risks you face,” he said. “Second, decide which risks you want to accept. Then you have to constantly measure and attribute the performance so that you’re taking the risk you intended. Finally, you must constantly recalibrate your portfolio risk exposure.”

Kelley compared the process to the training of a jumping frog in Mark Twain’s short story “The Celebrated Jumping Frog of Calaveras County,” in which one character decides to leave his frog with a stranger before a contest. “The lesson is, once you’ve gone to all the trouble of training your portfolio, don’t take your eyes off of it,” he said.

During several years leading up to the mortgage crisis last summer, many market participants wanted to get longer risk, given the benign credit environment and more than abundant liquidity, Kelley said. “Today, many of those same institutions are pulling in their horns and reducing their risk exposure,” he said.

The answer to their concerns is obvious, Kelley said. “With appropriate risk, there is opportunity. And there is a lot of opportunity today,” he said. “You can take advantage of that opportunity after you understand the risks you face, decide which ones you want to accept, measure constantly to be sure you’re taking the ones you want to take, and constantly recalibrate your position so that your frog, if you will, jumps higher,” he said.

Ratings agencies made mistakes in the mortgage crisis by attempting to apply ratings systems they used effectively in other asset classes to an area for which they possessed limited data, Kelley said. “With corporate data, they’ve been doing this since the 1920s,” he said. “It’s remarkable how consistent the credit experiences are over a long enough period of time — say, 10 years — for companies with the same credit metrics today and 40 years ago.”

The agencies’ corporate ratings are extremely helpful and worth using, Kelley said. “What they did in subprime mortgages surprises me,” he said. “They just didn’t test their assumptions enough. With our deals, we assume all the borrowers in our portfolio set at prime and prime is inverted to liable. That’s never going to happen, but we do that.”

Kelley’s comments were especially relevant today, given the changes in the credit market since summer 2007, said Mike Ott, a student in the Evening MBA Program who co-chairs of the student-led Investment Management Group. “He touched on all the analytical finance work Chicago is known for,” Ott said. “It was good to see it put into practice in the real world.”

Phil Rockrohr