As reported yesterday in The New York Times and Wall Street Journal, the government's bailout programs have created an incredible opportunity for private asset managers like BlackRock. Thanks to new initiatives like the Treasury Department's Legacy Securities Program, these firms could now be in a position to buy, sell, manage, and/or valuate the same types of toxic assets for the government and also for their private clients, potentially making huge profits in the process.
POGO is concerned, however, that the multiple roles played by BlackRock and other asset managers creates a serious potential for conflicts of interest. Yesterday we sent a letter to the Congressional committees overseeing the bailout to raise our concerns and to call for increased oversight of these conflicts.
Nobody's financial interests are more entangled than BlackRock, a firm that Bloomberg recently called the “dominant player in evaluating and pricing distressed assets.” BlackRock is one of four firms hired to manage the Federal Reserve Bank of New York's (“New York Fed”) $1.25 trillion mortgage-backed securities purchase program. BlackRock was also retained as the asset manager for all three of the New York Fed's Maiden Lane portfolios, which were created to facilitate JP Morgan's acquisition of Bear Stearns and the restructuring of the New York Fed's financial assistance to AIG. And as the Journal reported yesterday, BlackRock has been preliminarily granted a second-round interview to become one of five asset managers for the Legacy Securities Program.
To be sure, BlackRock is one of the most experienced firms around when it comes to asset management and valuation, so it's no surprise that both the Fed and Treasury are turning to them for assistance. But there are several reasons why Congress should take a second look at the government's contracts and arrangements with BlackRock and similar firms.
For starters, BlackRock has received three no-bid contracts to oversee the New York Fed's acquisition of toxic assets, including one where the fees were not established until after the contract was awarded. Although the Fed is not required to follow the same contracting rules and regulations that apply to most federal agencies, the Reserve Banks are supposed to follow internal acquisition guidelines which stipulate that “invitations to bid and requests for proposals should be sent to as many interested suppliers as possible to ensure competition.” Although Fed Chairman Ben Bernanke and then-New York Fed President Timothy Geithner have both pointed out that “exigent circumstances may require an exception to the normal competitive bidding process,” Congress should examine why one firm has repeatedly enjoyed such special treatment, especially since BlackRock's contracts have not been made available to the public.
Even more concerning, however, are the conflicts of interest that are likely to arise once firms like BlackRock enter into contracts and arrangements with the government. Our letter makes the point that these conflicts can have a wide range of consequences, including financial losses for the taxpayer, an unfair competitive advantage for the asset managers, and the continued erosion of public confidence in the public's ability to stabilize the financial system.
In his latest report to Congress (pp. 147-148), Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program (SIGTARP), goes into some detail describing how a conflict of interest would benefit the private asset managers participating in the Public Private Investment Program:
"By their nature and design, including the availability of significant leverage, the PPIF [Public-Private Investment Fund] transactions in these frozen markets will have a significant impact on how any particular asset is priced in the market. As a result, the increase in the price of such an asset will greatly benefit anyone who owns or manages the same asset, including the PPIF manager who is making the investment decisions....
The incentives [to overpay for an asset] exist, for example, even if the fund manager does not own MBS [mortgage-backed security] X but is merely managing other funds that hold MBS X, as the manager earns fees based on the value of that fund, a value that would, in this example, be significantly overstated (temporarily) as it can increase the value of that fund based on valuing, or “marking” the MBS X at the inflated “market” price that it set. The conflict can even exist if the manager holds or manages equity tied to the value of the banks from which the MBS are being purchased; here, using PPIF funds to overpay for bank assets may increase the bank's stock price, thus giving a greater profit to the fund manager." [emphasis added]
Of course, we've heard over and over again that the government will be protected from such conflicts by internal firewalls that separate the asset manager employees working on the government contracts from the employees making investments for private clients. Bill Gross, managing director of PIMCO, has even claimed that his employees working on the government contracts are "housed in a different building."
Nonetheless, POGO is skeptical of these ethical firewalls, especially given the weak conflict of interest policies issued by the Fed and Treasury. As has been pointed out in several public comments, Treasury's interim conflict of interest rule places too much responsibility on the contractors to disclose and manage their own conflicts of interest. In the case of the Fed, we haven't found any publicly available conflict of interest policy beyond an FAQ section on the New York Fed's website which states that "each investment manager will be required to implement ethical walls that appropriately segregate the investment management team that implements the Federal Reserve's agency MBS program from other advisory and proprietary trading activities of the firm."
In light of these lax policies, and the serious potential for conflicts of interest, POGO is calling on Congress to conduct a thorough review of the government's reliance on firms like BlackRock for asset management and valuation, and to consider whether ethical firewalls and self-disclosure are the best mechanisms for protecting the government from conflicts of interest.
-- Michael Smallberg