FOR somebody who has just stepped off a night flight from New York, Michael Thompson is remarkably cheery and animated when we meet in the Canary Wharf offices of Standard and Poor’s (S&P). Perhaps it’s the large coffee he admits to having drunk earlier or maybe it’s because he has become a more regular transatlantic commuter since he joined S&P as managing director of its Valuation and Risk Strategies (VRS) division in June 2008.
As the full extent of the credit crunch became clear, the second half of 2008 was certainly an exciting and interesting time for Thompson to head up the VRS arm of S&P, given that it provides financial market intelligence and risk-driven analytic insight into the credit markets for institutional investors.
But as somebody who appears pragmatic and with a can-do attitude to life, Thompson looks back on the end of 2008 as a painful but also a great time because it provided the opportunity to innovate and people took new ways of doing things seriously: “We got people telling us: ‘If I had known the kind of risk I was taking, I would have demanded a greater deal of compensation.’ People felt there wasn’t enough transparency and an insufficient understanding of the underlying risks.”
This kind of investor sentiment has informed VRS’s product development and approach. “We are out there looking very specifically at other pieces of information which might be derived from the marketplace. For example, we look at how well investors are being compensated through the marketplace for the bespoke underlying risk that they are taking,” says Thompson.
One way in which S&P is doing this is its new Risk-to-Price (R2P) product, which was launched in August. R2P is a relative measure of how well a security may be compensating its owner, through yield, for the embedded market and credit risks. Rather than the bottom-up perspective employed by S&P Ratings, from which Thompson is keen to distance his team’s activities, VRS harvests the market for information that is not currently collated and calculates the default risk from the marketplace.
“The markets are more and more inter-related so you really need to be able to take what the equity market is saying about a company’s credit and vice versa. You need to pull that all together to get a holistic picture,” explains Thompson animatedly, illustrating his point with his hands.
He points out that investors are no longer just asking whether they should buy or sell an asset but are actually asking themselves where the best value lies across a firm’s whole capital market structure. R2P scores help investors reach these decisions.
“We are highlighting and taking risk valuation to the next level. There are still elements of market risk that we haven’t covered, such as loss-given default, but we’re getting there,” he says, adding that R2P has received almost unanimous approval from most of the top financial institutions out there.
Credit risk valuation and analysis has become even more important in light of the recent Basel III regulations and the level of refinement has impressed Thompson.
“The big headline from Basel III was raising the Tier One capital but below that, another aspect that has been really interesting is the notion of being able to frame out a view of what effect counter-cyclical buffers might have in an adverse event. That’s frontier risk management and as a result of Basel III, we will be bringing new products to the market that allow for these capabilities,” he explains.
AD HOC TESTING
“This is the real advent of modern stress testing,” he proclaims. “It is important because both US and European policymakers have relied on the notion of stress testing as a way to instill confidence in the marketplace. That level of stress testing, although very laudable, was ad hoc. Now we should make a science out of it and not restrict its use to times of crisis.”
By developing even more robust products around stress testing, investors will be able to see a whole spectrum of different outcomes, helping them to make more informed decisions.
This, says Thompson, should act as insurance down the road in the event of further shocks. But while he doesn’t dismiss the possibility of further shocks, Thompson is positive on corporate securities, both investment grade and even some of the less savoury speculative grade ones: “Even if you do have a continued anaemic recovery, corporates are so well funded and there is such a discipline around the credit side of these companies that I don’t see major cataclysms.”
Nonetheless, he argues that while it’s a very tenuous time in the markets with the constant threat of inflation lurking around every corner like a bogeyman, “there are people paid to be in the business of taking risks and they want to take the smartest risk”. Thompson is at the forefront of VRS, which is trying to help institutional investors do just this.
CV | MICHAEL THOMPSON
Born: Thompson was born in New York but grew up just outside Chicago until he was 14, when he moved back to New York.
Lives: New York
Family: Married with two girls, aged seven and five.
Education: Hofstra College, a small private college on Long Island.
Career: Thompson started off in asset management, with his first finance job at JP Morgan. After just over five years he moved to Lehman Brothers where he spent four years. He then worked for RiskMetrics, a financial risk management firm, as a risk strategist. He then joined Thomson Financial – later Thomson Reuters – where he was managing director of Thomson Reuters Research.
Interests: “I am a real political junkie. Policy is interesting.” His little girls also keep him very busy.
IN FOCUS | RISK-TO-PRICE
Risk-to-price (R2P) was launched in August after two years of being created and refined.
Daily R2P scores are created for US and European corporate debt by evaluating their probability of default, volatility and option-adjusted spread (OAS). The higher the score, the better you are compensated relative to underlying market and credit risks.
R2P scores are divided into quartiles to provide a rank order assessment. A screening tool enables filtering of the bonds by quartile, OAS, duration, probability of default, yield, S&P’s credit rating and maturity.
It is currently only available for corporate bonds but VRS envisages R2P for municipal bonds in the US and potentially equities in the future.
Around 1,000 securities are being added every few months. There are currently around 1,600 European securities and 6,000 US securities.