In the annals of Wall Street history, the names WorldCom, Enron and Tyco yield a singular reference: credit default. If the annals included illustrations, the reference would be accompanied by a chart of a portfolio containing one of those companies plummeting to worthlessness. And if the illustration had sound, the only thing one would hear would be the asset manager of that portfolio screaming in anguish.
Even if that asset manager had a majority of great investments in his or her portfolio, the last few years of massive credit default on Wall Street have demonstrated that a positive investment does not necessarily cancel out a negative one. "Everyone got hurt over the last several years, and people realized that the harm from a wrong call far outweighs the help from correct calls," explains Mark Abbott, director and head of quantitative research, ALM and risk management at the Guardian Life Insurance Company of America Investments.
Abbott, who is also on the board of directors for the Professional Risk Managers' International Association, says that credit risk is inherently asymmetrical in terms of movement. "There can be a ripple effect triggered by credit deterioration. Because of huge risk aversion, the market price tanks rapidly. People say, 'Sell now and ask questions later.'" As a result, he continues, "Looking for early warning signs [of credit default] is worth more than making correct investment calls."
Before the market experienced these substantial company defaults, there was little that portfolio managers on the buy side could have done to detect them. Since other tools were not widely available, traditional asset managers typically valued companies in their portfolios using fundamental analysis, explains Gavin Little-Gill, a senior analyst at TowerGroup. This type of fundamental examination measured only the absolute-default probability of a company, based on such qualities as its financials, management team and position in the marketplace.
While credit default may not be making the front pages as often as it had been in the last couple of years, company downgrades are still a common phenomenon. In the current environment, buy-side firms are realizing that it is time to add quantitative analysis to their portfolio-management process. This mathematical modeling of historical and market data could help asset managers eliminate the next downgraded company from their portfolio lists.