We Need Open Derivative Models

Before I knew anything about the finance industry, if someone had thrown out the name “Blackrock” I would have conjured up a scene from the Wild West, a cattle rancher hiring a gunslinger to roust out the sheep farmers and take control of the town. But now, of course, I know that BlackRock is a financial behemoth with $1.5 trillion in assets under management -- soon to be over $2 trillion due to its purchase of Barclay’s asset management business. But of more note than its asset footprint is the mantle BlackRock is gradually assuming as the arbiter of value.

BlackRock won a set of contracts to provide analytics for the New York Fed’s trillion dollar mortgage-backed purchase program. Now, BlackRock may end up with an NAIC contract to analyze the mortgage-backed securities in insurers’ portfolios.

I do not mean to diminish BlackRock’s laudable role in assisting in many ways with the financial crisis – coming forward when a number of other large firms demurred. But as one contract is piled on another, their models will become the standard for pricing mortgages, complex derivatives and structured products. Unlike the money management business, which is competitive and relatively transparent, this is a monopoly ready for the making. A monopoly because the more institutions, industry associations and regulatory bodies that employ their services, the more they become the de facto standard. Over time, auditors, clients and equity holders – perhaps even regulators – will start saying, “Well, it is nice to see what your internal models have to say about your portfolio value, but we want your portfolio benchmarked using the BlackRock model.” A BlackRock seal of approval; BlackRock, the JD Powers of portfolio quality.

Here are the problems with this:

First, of course, is the well-known issue of allowing a private enterprise to have monopoly control of a utility – in this case a de facto replacement of the rating agencies (not a bad thing in itself) by putting one firm in the position of providing the benchmark pricing of financial products. Second, there are natural conflicts of interest given that BlackRock is also the asset manager for the New York Fed’s Maiden Lane portfolios and has raised over half a billion in private capital to purchase legacy securities as part of PPIP. (Though I should add that BlackRock is aware of this issue and has stated the firm has strict internal controls preventing any valuation services from being gamed by its investment arm. Which should make us all feel a lot better).

But the most critical problem is that its approach is at variance with the broadly held view that we need to have transparency in the derivatives markets because, unlike, say, RiskMetrics, BlackRock does not share the specifications of the models it employs. We don’t really know what these models are doing. Valuations based on a black-box BlackRock model, or, for that matter, anyone else’s black box model, do not get us the transparency we need. I don’t care what a trading desk uses for its decision making, but when it comes to valuations that carry beyond the firm, we need to be able to see and critique the models that are being used. If a model is to become a standard, if it is going to be used for regulatory or other benchmarking purposes, it should be transparent and subject to peer review.

Which gets to a simple point: If we want to go down the path of standardized valuation and comparability in these complex portfolios, we need open derivatives models. One thing we should have learned from the rating agency debacle is that even if we put aside the issues of monopoly power and conflict of interest, we cannot stop with having the proprietor of such models say, “Trust me, I know what I’m doing.”