‘After Lehman fell, you just hoped you weren’t the first one to go down’

Bennett W Golub, one of the founding partners of BlackRock, was stressed. It was the height of the financial crises and the money markets in the United States were in trouble. Needing a break, he decided to get some candy. But here, too, he was stymied. While the candy machine needed a single dollar bill to dispense the goodies, all he had were twenties or higher.

“That moment crystallised in my mind the fallacy of believing that you could always use the markets to convert an asset into liquidity,” he told DNA.

In an interview during a recent Mumbai visit, the chief risk officer of the world’s largest asset manager talked about the bad old days, some lessons that financial institutions have learnt and some that they may not have. As for the candy, well it was got with a temporary loan — just like from the US treasury. Excerpts:

It’s been over two years since the collapse of the Lehman Brothers, and a lot of water has since passed under the bridge.  How would you place the appetite for complex products among investors now?
My general sense is that there is less of an appetite for complexity now than there was before at both the retail and institutional level. When a dealer sells a complex product, they tend to make more money because there is less direct competition as it is less of a commodity. At the same time, at least for the time being, memories of the problems that had been caused are still there, and the potential to use the complexity to obfuscate as opposed to innovate to a constructive ends remain.

So my sense is that there continues to be less appetite for complex products than there was two or three years ago.

Does that necessarily stifle the urge for potentially dangerous innovation?
There will always be the desire — and need — for a great new innovation, a great new idea.  Yet we continue to have concerns that there are some complex products masquerading as simple products. Sometimes the complexity is not always apparent to investors. In the ETF (exchange-traded fund) space, there are certain ETFs which are backed by derivatives. And those derivatives can sometimes be collateralised by less than pristine collateral.

They masquerade as ETFs but are really, in effect, very complex structured notes. The traditional ETF is a very transparent product — the sponsor actually publishes a list of its securities and will make markets to create and redeem units of the ETFs using that public list.
Alternatively, you can have a similar swap-based ETF where you have only one swap counter-party who is often also the ETF sponsor. What they are collateralised by is anyone’s guess. We are concerned that there is some very challenged collateral being used with these products. There is an expression, a wolf in sheep’s clothing — certain ETFs have complexity and risk hiding in what otherwise seems like a simple products.

How common are such structures?
There is a segment of the market which is growing in that manner. Some of these derivative-based ETFs are also leveraged. They are leveraged two-to-one, three-to-one or can even have negative leverage. At BlackRock we certainly try to use transparent cash-based structures whenever possible. We can’t always do it perfectly as some markets don’t lend themselves to that approach.

For instance, in certain markets there are some restrictions on the ability to directly own shares which means that you have to own them indirectly. But subject to those constraints we have generally tried to when possible ,  have a simpler structures for our ETFs.

How would you characterise the challenges that you faced as an asset manager in the wake of the financial crises?
There were many challenges, and I actually wrote two articles on this topic.  Let me discuss one particular challenge. In the depths of the crises, we were trying to gain liquidity in some of our money market type funds.  We suddenly experienced major difficulty in selling commercial paper issued by large broker dealers.

BlackRock is the largest asset manager in the world. You would think that if anyone was going to have success knocking on the door and getting a bid on commercial paper, it would be us. But we had faced situations where we were unsuccessful, and it was very stressful.

I remember at one point during the crisis walking over to the candy machine in our office — I needed a candy bar to deal with the stress. I went to the machine, and the machine required a $1 dollar bill. As it turned out that day, while I had a lot of money in my wallet, I didn’t have a $1 dollar bill.  I had a $20 bill, a $50 bill, a $100 bill  but not what I needed  to buy the candy bar.  I looked at the candy bars through the glass,  and I  looked at my wallet full of cash. Yet I couldn’t get the candy bar.

Suddenly, a light bulb went on in my mind and I realised that the problem I was having with the vending machine where I certainly had the resources to do the transaction (buying the candy bar), but I could not get the liquidity was exactly what was happening in BlackRock’s ‘war room,’ as we called it, where we were unable to convert our assets into cash through the markets.  

Did I have a temptation to pound the machine with my fists? Yes, I was tempted but I didn’t do it.  Fortunately somebody came by, and I was able to grab the candy after he floated me a loan on my personal credit. Ultimately, this is what the US treasury also had to do.

That moment crystallised in my mind the fallacy of believing that you could always use the markets to convert an asset into liquidity.  I realised that you could have plenty of assets and still not necessarily be able to function due to a breakdown in liquidity.

Which would you say might have been your scariest moment of the time?
After the collapse of Lehman Brothers, there was a large ‘run on the bank’ where investors were rapidly exiting money-market funds. When I looked at the numbers it became apparent that within a couple of days, the entire US money market was going to collapse.

Fortunately, we had managed our money market portfolios exceedingly well.  We were in good shape for the near term, but when you looked at the trends you realised that no matter how good a job we did, it was just a matter of time before the market would collapse. You just hoped that you were not the first one to go down.

That was a really scary situation when I realised the actual consequences of the crises.

Has there been a change in the approach to risk management that has been seen in recent times among the various financial instructions that you deal with?
As part of my job I meet with the chief risk officers (CROs) of all of the major global investment banks to share views and to get a sense of who they are, how their organisations operate, and to judge how ‘on the ball’ are their institutions.  I would say, without a doubt, that the organisational attention and focus that these CROs get today is much higher than it was three years ago. And I would say that most of the people that we are meeting are very sharp people who know what they are talking about.  I can’t say true 100% of the time — I’ve been disappointed by some of the discussions with some of the CROs who seem to be heading back to old ways of thinking or are not plugged in as deeply as you would expect.  But on balance I would say that the person in that job is better today than he or she was before. There is more organisational support and almost without exception there are more resources available.

I also find that the regulators are now paying a lot more attention.  There are parts of BlackRock which are subject to different types of regulation, and my team has  had quite a few in-depth discussions with the regulators.  There now seems to be a lot more detailed interest in what we do and how we do it.

There certainly has been a lot of discussions about Basel III and about regulations required under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

But I sense that the conviction to rigorously put all of the reforms fully into place is fading a little bit. People start over, and their memories begin to fade.  Also,different political sentiments are starting to appear.  I think a fair number of good reforms have been set in motion through these initiatives, and the question really is, what will finally get over the finish line.

I would predict that the increased use of exchanges will make the system better and safer,  for sure, but will fall short of probably what we need to do. I think we will end up with a better system but not as good a system as we would probably need.

It’s funny how you gain perspective when you live through history. When you read the history books, you see what happened in 1929 and 1933, and it seems like similar things are happening now.   Peoples’ memories fade pretty quickly and their priorities change.

So with the lobbying that one hears about, especially from investment banks, we could see some dilution of focus?
I don’t know that its fair to point only at one type of institution. I’ve heard some of the discussions, and the pursuit of self-interests is not unique to investment banks.  Everyone likes to pick on the investment banks but they are not unique in wanting to try to advocate for their positions.

Whether its investment banks, commercial banks, insurance companies, or even asset managers, everyone has their own narrow perspective. So I think there would be some dilution of focus.

I still think we’ll end up with a better system but I think the improvements would fall short of what would ideally make the business better for everybody.

BlackRock is credited to having foreseen that sub-prime valuations were becoming a major issue, what would you say helped generate this insight?
We had some short positions many sub-prime instruments, the same instruments with different dealers. And when we would get the mark-to-markets from each of those dealers for those positions, we would see that the exact same positions  being marked by different dealers at very, very different levels.

It seemed like there were some dealers who were dramatically overvaluing their sub-prime positions. It was certainly very odd to see this, but since they were over-the-counter(OTC) contracts, there was nothing we could do about it but argue with them on a one-on-one basis.

That was certainly a signal, that you had wide valuation disparities. It dawned on us that the reason that they were doing this is because if they would mark their positions with us, since they were on the other side of the trade, they would have to mark down their whole inventory which they were very resistant to do.

We had also seen that there was a tremendous influx of people and participants into the sub-prime market. Everyone was rushing to originate the product. Experience shows that market tends to overshoot when everyone’s trying to do the same trade at the same time.

Lastly, we had a deep understanding of the CDO (collateralised debt obligation) market.  We could observe the demand for securities by the CDOs, particularly the pressure to add yield oriented AAA securities.  There were many clues which, with 20-20 hindsight, you should have known exactly what they all meant.

We were not smart enough to instantly pick up the full significance of each of them,  but the combination of them all made us believe that the sub-prime market was very rich.

We also were not so smart as to foresee how bad it would ultimately  get. Imagine that you think there is going to be a flood so you move to the roof on the fifth floor. 

When the flooding begins, you look like you are a very smart guy as the first floor, the second floor and the third floor gets flooded.  As the flood continued to rise, though, there were certainly more than a few wet feet in some of our portfolios...as well as some impaired positions.

I wouldn’t pretend that we had perfect insight. But we definitely had a good sense of direction and we got that part right. On balance, we were more right than many other market players, but we also took our share of bruises.