Induction of Edward I. Altman

Inducted November, 2001

Close friend and colleague Martin S. Fridson.
Mr. Fridson’s introductory remarks follows.

Honored guests, fellow analysts, ladies and gentlemen. Speaking on behalf of Ed Altman is a humbling experience, because it has compelled me to examine his extremely lengthy catalogue of achievements. Surely, there are not enough days in the calendar to accommodate so many productive activities. The inevitable reaction must be, “How have I been frittering away MY time?”

Ed is the Max L. Heine Professor at New York University’s Stern School of Business. He also directs fixed income and credit research at the school’s Salomon Center, where he is vice-chairman. Before taking on that role in 1990, he chaired the Stern School’s MBA program for twelve years. In addition, he serves as Executive Editor of the Journal of Banking and Finance, Advisory Editor of the John Wiley Frontiers in Finance Series, advisor to the Centrale dei Bilanci in Italy, as well as to several countries’ central banks and has recently been elected President of the Financial Management Association. This is not to mention his other volunteer activities, which include the chairmanship of the InterSchool Orchestras of New York and service as a trustee of the Museum of American Financial History.

While keeping all of these balls in the air, Ed has found time to author or edit almost two dozen books and more than one hundred scholarly articles straddling the fields of finance, accounting, and economics. It’s this part of his work that the Fixed Income Analysts Society particularly honors in inducting Edward Altman into its Hall of Fame. His most famous contribution involves the quantitative modeling of bankruptcy risk, highlighted by the introduction of the Z-score in 1968, Zeta analysis in 1977, and Emerging Market Scoring in 1995. These models have provided the foundation for innumerable studies of credit risk, all around the world. In 1997, when J.P. Morgan introduced its widely heralded CreditMetrics® model, Altman’s works accounted for by far the largest number of sources cited. One year later, the World Bank aggregated the Z-scores for firms in each of several Asian and other developing countries. The World Bank concluded that the scores generated unmistakable signs of financial distress prior to the beginning of the 1997 Asian crisis.

As impressive as these accomplishments are, Ed Altman is even more highly esteemed by people who have had the fortune of dealing with him on a personal level. His former students describe him as surprisingly down-to-earth, approachable, and exceptionally generous with his time. According to some, his liberal approach to time resulted in his classes sometimes starting as much as fifteen minutes late, giving rise to the term “Altman Standard Time.” But while he created an atmosphere in his classes that was not intimidating, the substance of his teaching was formidable. Ed further distinguished himself by effectively integrating the theoretical and practical sides of finance. A number of his students were so keenly affected by his course on corporate bankruptcy that they made career shifts and now rank among the foremost practitioners of distressed debt investing.

Altman has forgone the material rewards of the nonacademic world

The excellence that Ed has brought to the classroom is an inevitable consequence of the high standard he sets for himself. This intensity also manifests itself in a strong competitive drive, particularly on the baseball diamond. At the Stern School, the claim that Ed was hired primarily because the departmental softball team needed a shortstop, and it was discovered only later that he could also teach finance.

With his financial insights and desire to excel, you would think that some brokerage house or money management firm would have long since lured Ed Altman out of academe. Well, don’t imagine they haven’t tried. It’s just a further measure of Ed’s character that he has forgone the financial rewards of the for-profit world to enjoy the sort of life style to which we all secretly aspire. Ed and his lovely wife Elaine travel the world and find a lot of time to enjoy the sea breeze at their home in the Hamptons. Let me hasten to reassure you that they are not hurting financially, but Ed and Elaine have put making a living into the proper perspective with making a life.

Because I have observed these fine personal qualities at close range over a number of years, the task of introducing Ed Altman is a rewarding experience, even though it is humbling. I first met Ed in 1984 when I joined Morgan Stanley. A few months before I arrived, he had begun a large consulting project with the company.

Practitioners were not initially well-disposed to quantitative methods

Well before that time, I had heard of some Z-scores published by a professor at New York University. That’s not to say that I had actually read his work, which is about the last thing a practitioner was likely to do in those days. The more typical response to development of a quantitative tool for credit analysis was to regard it as a threat. Analysts reasoned that if management found out that it was possible to predict defaults or rating changes with a statistical formula, they’d fire all the analysts and replace them with a computer program. In reality, these concerns were not well-founded. Nevertheless, corporate bond analysts regarded it as their mission to disparage the work of the ivory tower eggheads. They had to educate management about the failure of quantitative methods to capture credit risk in all its rich, qualitative subtlety. The bottom line is that what I had heard about Z-scores was not especially complimentary. And to the extent that I had my own ideas on the subject, I wasn’t too enthusiastic about quantitative approaches. For me, the whole appeal of credit risk lay in the unsystematic elements that created opportunities precisely because they were hard to model and, therefore, required people to think outside the box.

Under the circumstances, a lesser man than Ed Altman might have viewed me as a danger. After all, he had landed a prestigious consulting arrangement with a topflight investment bank on the strength of his international reputation in bankruptcy prediction models. Ed had negotiated this deal with the head of fixed income research, Bob Platt, who came from a similar quantitative/academic background. Here I was barging onto the scene as head of corporate bond research with an entirely different orientation. From Ed’s standpoint, all I could do for him was to throw a monkey wrench into the works.

Altman has put his mission above politicking

Among the things that makes Ed Altman special, though, is that he’s an open and honest person. He has a sense of mission, which he puts ahead of petty politics. Instead of positioning himself for a turf battle, Ed quickly got me involved in his study of the high yield market. It turned out that our work was highly complementary. And once I got a first-hand look at his ZETA analysis, as opposed to the caricature presented by people who were innately hostile to the concept, I saw that it genuinely represented a great advance in the field. One problem I had previously encountered in credit analysis was assessing the risk of an issuer with some good statistics and some bad statistics. For example, suppose that a company had comparatively good fixed charge coverage within its industry or rating peer group, but also had a comparatively weak capital structure. What was an analyst supposed to do — arbitrarily assign coverage a weight of two and leverage a weight of one? The correct answer is what Ed’s analysis did, which was to test the data against actual default experience and let the weightings be assigned by the outcome.

Z-scores enhanced fundamental analysts’ ability to gauge default risk

Seen in the proper light, Z-scores were not a threat to credit analysts’ jobs, but a conceptual insight that enabled them to do their jobs better. Institutions were not about to start managing their corporate bond portfolios entirely on the basis of a quantitative model. They needed humans to assess the many contingencies that no model could capture. And the institutions had to have analysts checking the quality of the numbers that went into the analysis. They understood that some issuers would manipulate their financial reporting to make themselves look good under whatever system investors set up. But at the same time, the analysts had to put rigor into their work by demonstrating that there was an empirical connection between the ratios they were calculating and the probability that a company would meet its obligations. Establishing that link was the true significance of Altman’s breakthrough. Ed’s pioneering research in modeling bankruptcy risk made him the logical candidate to inject some rigor into analysis of high yield bonds, when that sector began to develop as an institutional market in the 1980s. He proceeded to fulfill that role, but it was no tea party. At the time, high yield bonds were caught up in the controversy surrounding hostile takeovers and corporate restructuring. The financial press, always looking for new forms of financial hanky-panky to uncover, saw so-called junk bonds as a mire of disinformation and deception.

He calls them as he sees them

In this highly charged environment, you can guess what happened when Altman’s very rigorous calculations produced a slightly higher annual default rate than the promoters of high yield bonds had previously reported. The press used his findings as a club to beat the brokerage firms, who did not necessarily want that much rigor. Up went the cry from Wall Street: “Couldn’t you try to be a little more positive, Dr. Altman?” “Surely, Dr. Altman, you have enough imagination to find a way to make the numbers better than they really are?”

A few years later, another group of academics published a study that looked at the default data from a different angle. The usual way of thinking about the question

1. How much speculative grade debt existed at the beginning of the year?
2. How much of it defaulted during the year?
3. Dividing the second figure by the first produced an annual default rate.

The 1989 study that came to the attention of the press took a different tack:
1. How much speculative grade debt was issued in a given year?
2. How much of it defaulted OVER THE NEXT ELEVEN YEARS?
3. Dividing the second figure by the first produced a cumulative, as opposed to an annual default rate.

Journalists’ shocking revelations: 3 x 11 = 33

This led to a discovery that the financial press considered monumental. That discovery was that 3 times 11 equals 33. If you count defaults over eleven years instead of over one year, the rate (are you ready for this?) is ELEVEN TIMES AS HIGH. Whoa! This is Nobel material. The next thing we knew, the press was reporting that a remarkable new study disproved Altman’s claim that the default rate on those evil junk bonds was only 3 percent. Actually, according to the crusading journalists, the rate was more than ten times as high as that!

Barron’s exposed the exposé as a colossal error

Within the week, Barron’s unmasked this supposed exposé as a colossal error. The new study’s 30 percent-plus rate was not comparable to Altman’s 3 percent rate in any way,> shape, or form. It was just a different way of looking at the same data. And on top of that, Altman himself had already looked at the data in this alternative manner, calculating a cumulative default rate in the neighborhood of 30 percent. He called this figure the “mortality rate.”

It’s impossible to err in both directions at the same time

None of this swayed the reporters. They were convinced that they had stumbled onto a new Watergate scandal. I said to them, “A few years ago, you were reporting that Altman was overstating the default rate. Now you say he’s UNDERstating it. Which is it? It can’t be both.” Logic had no impact, however. The latter-day Woodward-and-Bernsteins had their story and they were going to stick with it, come hell, high water, or the unwelcome intrusion of reality.

I’m happy to say that Edward Altman’s reputation for impartial research has proven more durable than some teapot tempest concocted by slipshod reporting. His annual default rate, mortality rate, index of defaulted bonds, index of defaulted banks loans, and recovery rates on defaulted bonds have all become standard data series for practitioners. I have cited his research countless times, confident that doing so would enhance the credibility of my own work.

Aside from all that, I’ve grown very fond of Ed over the years. About a decade ago, I even wrote a bit of doggerel in celebration of his birthday. That was before the founding of the Fixed Income Analysts Society Hall of Fame, but as you’ll hear, the poem turned out to be
prophetic:

Tinker to Evers to Altman
In the Financial Analysts Hall of Fame,
The brightest plaque bears your face and name,
For your production ranks with Berra’s
In hits and runs, with a few Type 2 errors.
No Cooperstown scribe’s profuse statistics
Can match your data-based ballistics;
You’ve knocked down fences in the credit risk area,
While leading the majors in honoraria.

The firms that you champion pay off their debts
With the regularity of victories by the ‘62 Mets.
And even George Steinbrenner’s string of violations
Is shorter by far than your list of publications.

The Willie Mays of bankruptcy prediction

Your sturdy hands are swelled by calluses
From years of multiple discriminant analysis.
You’re the Willie Mays and Orlando Cepeda
Of bankruptcy models with names that start with “zeta.”
More erudite than Shoeless Joe,
More versed in banking than DiMaggio,
As clear and concise as the Old Perfesser,
In decorum, to Dean you’re a worthy successor.

These facts have now brought you into the Golden Circle
Not entered by Maris or even Fred Merkle;
Your latest accomplishment — fifty round trippers —
Will be duly recorded by Topps and by Lipper’s.
You’re a leader, a hustler, a scrapper — in short,
A Most Valuable Scholar and a helluva good sport.

So now, although it’s akin to Marv Throneberry 1 introducing Babe Ruth, I’m very proud to introduce the newest member of the Fixed Income Analysts Society, Dr. Edward Altman.

Reprinted by permission.
Copyright ©2001 Merrill Lynch,Pierce, Fenner & Smith Incorporated