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Mandelbrot Beats Economics in Fathoming Markets: Mark Buchanan

Dec. 6 (Bloomberg) — The possible collapse of the European monetary union, at least in its current form, brings home the truth that there’s little in economics that is certain. We’re again “thinking the unthinkable,” as we were a few years ago when we suddenly realized that financial engineering hadn’t banished financial crises, and that 70 years of relative stability since the Great Depression didn’t guarantee a thing.

It seems that we’re complete suckers for the illusion of certainty and the seeming unlikelihood of the unthinkable, even though financial and economic history is one long string of crises. This time always seems different, until it turns out not to be.

Nothing in mainstream “neoclassical” finance theory explains these persistent crises. Almost without exception, economists since Adam Smith have viewed economic systems as being in balance or equilibrium, and as having a natural tendency to return there after any disturbance. In this view, crises can be understood only as anomalies, the consequences of unusual outside shocks.

All this makes for tidy and comforting theory, with simple mathematics, but it fails utterly to account for the most basic market dynamics. Most notably, large and violent events — like the stock market crash of 1987 or the flash crash of last May — happen far more frequently than equilibrium theories suggest. In fact, the pronounced frequency of market upheavals is precisely what’s most constant in economics.

Over the past 15 years or so, physicists have demonstrated this in mathematical studies of market volatility. Inspired by work of the mathematician Benoit Mandelbrot in the 1960s, these scientists have used enormous sets of historical data — hundreds of millions of minute-by-minute prices stretching over more than a decade, and daily and monthly prices over half a century — to show that large market movements, up or down, follow a single mathematical pattern.

Larger movements of, say, 10 percent to 15 percent, are less likely than movements of 3 percent to 5 percent. And the probability of a movement decreases in simple inverse proportion to the cube of its size: If moves of 5 percent or more have a certain likelihood, then moves of 10 percent or more are 8 (2 cubed) times less likely, and moves of 20 percent or more are in turn 8 times even less likely. But they still occur with some regularity.

This pattern, it turns out, can be seen in markets for stocks, foreign exchange and futures around the world. And it is every bit as regular as the statistical patterns physicists know for the movements of molecules in solids, liquids and gases, or for innumerable other physical phenomena. It’s too regular to be an accident, and it is as deserving of fundamental explanation as anything in the rest of science.

‘The Fat Tail’

There are practical implications, of course, as Nassim Taleb explored in his book “The Black Swan.” Among other things, this particular pattern — scientists describe it as a “fat tail” in the probability distribution — suggests that really big movements are much more common than we might suppose. Thinking of markets in terms of the usual statistics that apply to things like people’s heights or weights or test scores leads to gross underestimation of the risks of rare catastrophes.

A credible economic theory of markets — something we do not yet have — would explain why the distribution of market returns shows such a preponderance of large events. It would account for why the mathematical form of this distribution is so uniform in markets the world over.

And, importantly, it would explain why markets share the same pattern with many other natural systems. Look, for example, at the flow of traffic on the Internet, solar flare activity on the Sun, the course of biological evolution or earthquake frequency on the San Andreas fault, and you see patterns strikingly similar to those in financial markets. All these systems and many others exhibit a naturally irregular rhythm in which long periods of relative quiescence are sporadically broken by bursts of intense upheaval.

The mathematical similarity between markets and other natural systems goes deeper still. Consider volatility — a measure of the momentary vigor of a market’s erratic movements up and down. Eugene Stanley, a physicist at Boston University, and his colleagues have shown in recent studies that bursts of high volatility in the stock market tend to cluster in time in the same way that earthquake aftershocks do. They follow a precise pattern known as Omori’s Law — named for Fusakichi Omori, the Japanese seismologist — which describes the likelihood of aftershocks in the days and weeks following an earthquake.

This similarity between market movements and earthquake aftershocks seems weird if you think of a financial market as a system in equilibrium that naturally balances people’s conflicting aims and desires. But it looks less weird and even quite natural if you think of a market as just another system that, like the Earth’s crust, is perpetually driven out of balance by the action of various forces, and responds to those forces in complex, dynamic ways.

It’s not so surprising that the best emerging models of markets look a lot like models of disequilibrium processes in other areas of science. They eschew the “rational agents” of neoclassical economic theory and instead view markets as systems involving interactions among people and companies with realistic characteristics — prone to mistakes, always learning and adapting, and often copying what others do. These models see markets as driven by feedback and instability, as is the case with most other natural systems.

It’s fair to say these models don’t yet give us an adequate understanding of the basic patterns we see in markets, but they at least move in the right direction by taking the historical data seriously and trying to explain it. Nothing in mainstream economics seems as likely to succeed in this. “I urge students to read narrowly within economics, but widely in science,” Vernon Smith wrote in his 2002 Nobel Prize for economics lecture, because “within economics there is essentially only one model to be adapted to every application.”

Simple ideas of equilibrium and balance may flatter our Platonic prejudices, but they don’t fit the real world. Nothing in the mathematics and physical science of the past 30 years stands out so much as the increasing importance of the irregular, the chaotic and the disordered in every part of the natural world. In many cases, this disorder isn’t simply random, but rather contains important regularities. Finding the expected disorder in the marketplace, and understanding its origins, could give economics a much stronger scientific foundation.

(Mark Buchanan, a theoretical physicist and the author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,” is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: Mark Buchanan at buchanan.mark

To contact the editor responsible for this article: Mary Duenwald at mduenwald

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Smallest Hedge Funds Assets Rebound as Clients Seek ‘New Blood’

June 10 (Bloomberg) — The world’s smallest hedge funds struggled to raise money in 2010. This year, investors want in.

Funds managing less than $5 billion increased assets by $16.3 billion in the first quarter after adding $10.7 billion of new money in the whole of 2010, according to estimates from Hedge Fund Research Inc. Firms with $500 million to $1 billion of assets had the biggest reversal of fortune, bringing in $4.7 billion in the first three months of the year after $2.8 billion of net outflows in 2010.

“Investors are looking for new talent and new blood,” said Dominic Freemantle, a London-based managing director at Morgan Stanley who helps the firms attract money. “We are definitely starting to see some of the small and mid-sized managers raise decent assets.”

Clients who sought stability in big hedge funds after the collapse of Lehman Brothers Holdings Inc. roiled markets three years ago are increasingly looking at smaller firms in a search for better investment returns, clients and consultants say. Smaller firms are also seeking investors at a time when some of the biggest hedge funds have stopped taking money, said Craig Stevenson, a senior investment consultant at Towers Watson & Co. in London.

“The inflows have to go somewhere,” said Stevenson, who helps pick hedge funds for pension funds and other clients that oversee about $20 billion. “People are less concerned about firm risk and business risk.”

Saba, Pelham

Firms that have attracted capital include Saba Capital Management LP, the fund started by former Deutsche Bank AG credit trader Boaz Weinstein, Hutchin Hill Capital LP and Pelham Capital Management LP.

Smaller funds have the potential to outperform in the months ahead as markets react to Europe’s sovereign debt crisis, inflation and the end of a program initiated by the U.S. Federal Reserve to buy $600 million of Treasuries, said Saleem Siddiqi, a London-based partner at Tapestry Asset Management LLP.

“There are a lot of unknowns on the radar screen,” said Siddiqi, whose company tailors hedge-fund holdings for institutional investors. “Being nimble is imperative to navigate these choppy waters.”

Size shouldn’t be an obstacle to raising money if managers can show they’ve produced good returns for two to three years and posses a “strong pedigree,” meaning they’ve previously been a trader at a Wall Street investment bank or well-known hedge fund, said hedge-fund investor Henrik Molin, head of development at Frey Quantitative Strategies Ltd. in London.

Hutchin Hill

Weinstein started New York-based Saba in 2009 with $150 million. The fund, which posted an investment gain of 11 percent in 2010, now oversees $3 billion, according to two people with knowledge of the matter, who declined to be identified because Saba is a private firm.

Assets at Hutchin Hill have jumped to $1.5 billion from $350 million after the New York-based hedge fund began to take money from new clients last year, two people with knowledge of the matter said.

Neil Chriss, a former Goldman Sachs Group Inc. trader who later managed a portfolio at SAC Capital Management LLC, started Hutchin Hill in 2008 with $300 million from Renaissance Technologies Corp. founder James Simons. Hutchin Hill, which trades stocks and bonds, gained 7 percent last year after rising 17 percent in 2009, according to an investor.

Ross Turner founded Pelham in 2007 after leaving Lansdowne Partners Ltd., a $16 billion hedge fund based in London that bets on rising and falling stocks. Pelham’s assets have increased to $1.7 billion from $57 million, investors say. The London-based firm rose 13.5 percent in 2010 after gaining 26.7 percent in 2009, according to data compiled by Bloomberg.

‘Definitely Easier’

“It’s definitely easier to raise money than it was two years ago,” Turner, 33, said. “It’s still difficult, but you will find interest if you have the right product.”

Saba’s Weinstein and Hutchin Hill’s Chriss declined to comment.

Hedge funds on average rose 8 percent in 2010 and 9 percent in 2009, Bloomberg data show. The smallest hedge funds, those with less than $100 million of assets, reaped an annualized average gain of 13.5 percent from 1996 to 2009, according to a September study of more than 4,000 firms by PerTrac Financial Solutions. Firms managing between $100 million and $500 million returned 10.7 percent a year on average over the same period. Those with more than $500 million increased 9.8 percent, the New York-based investment-software company said.

Favorable Terms

One attraction of smaller firms is that they will sometimes accept money on terms that are more favorable to investors, said Jeff Majit, head of European hedge-fund investments for New York-based Neuberger Berman Group LLC. Hedge funds typically charge investors 2 percent of assets under management to cover performance costs and 20 percent of any profits.

“We’ve had more success getting discounts on management fees, discounts on incentive fees and full portfolio transparency with emerging managers,” said London-based Majit, who’s firm allocates about $4 billion to hedge funds.

Bigger firms that are considering closing funds to new investors include Steve Cohen’s SAC Capital Management LLC. The $14 billion Stamford, Connecticut-based company told clients last month it may stop accepting money into the firm’s largest fund to ensure returns remain high. Daniel Loeb’s Third Point LLC, the New York-based firm that oversees more than $5 billion, plans to close its funds to new investments.

Och-Ziff Funds

Too be sure, many big firms remain open. These funds have the capacity to absorb the multimillion-dollar checks written by sovereign-wealth funds, pension funds and endowments and they are still attracting most of the money coming into the industry.

Inflows from clients and investment performance have added $2.4 billion to Och-Ziff Capital Management Group LLC’s funds this year, increasing the New York-based firm’s assets to $30 billion at the end of May, according to filings with the U.S. Securities and Exchange Commission.

Firms such as Och-Ziff that manage more than $5 billion got half of the $32.5 billion raised by hedge funds in the first quarter, according to Chicago-based Hedge Fund Research. The biggest hedge funds received 80 percent of the $55.5 billion investors added to the industry in 2010.

The inflows mark a turning point from 2008 and 2009, when hedge funds of all sizes experienced outflows of $285.6 billion. The redemptions were a consequence of 2008, when the industry lost 19 percent of investors’ money on average and a record 1,471 firms went out of business.

To contact the reporter responsible for this story: Jesse Westbrook in London at jwestbrook1

To contact the editor responsible for this story: Edward Evans at eevans3

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Fink Builds BlackRock Powerhouse Without Goldman Sachs Backlash

Dec. 10 (Bloomberg) — As chairman and chief executive officer of BlackRock Inc., Larry Fink controls more money than Germany has gross domestic product.

BlackRock is the world’s biggest asset-management firm, a $3.45 trillion powerhouse that is Wall Street’s largest trading partner, set to pay investment banks $1 billion in fees this year. It manages $1.4 trillion for public pension funds in states including New York, New Jersey and California, and invests $240 billion for central banks and sovereign wealth funds such as the Abu Dhabi Investment Authority.

The company serves as the U.S. Treasury Department’s go-to source for private-sector financial expertise and managed at least $150 billion in toxic assets on behalf of U.S. taxpayers after the 2008 bailouts of American International Group Inc. and Bear Stearns Cos. While running the company is a team effort, Fink, 58, is BlackRock’s brain, and BlackRock, increasingly, is Wall Street’s, Bloomberg Businessweek reports in its Dec. 13 edition.

“There’s no bank, no sovereign wealth fund, no insurance company that’s as large as BlackRock,” says Ralph Schlosstein, a co-founder who left in 2007 and is now CEO of Evercore Partners Inc., a New York-based investment bank. “BlackRock today is one of, if not the, most influential financial institutions in the world.”

In light of all this, it’s surprising how few people beyond Wall Street are familiar with Larry Fink and BlackRock. Founded in 1988 as a bond-trading shop, BlackRock has somehow reached financial omnipotence while remaining out of the public eye, escaping the scorn, and the acclaim, so often heaped on the nation’s premier investment bank, Goldman Sachs Group Inc.

Investors, Not Traders

Although BlackRock competes with Goldman’s much smaller asset-management unit, the two firms are fundamentally different. That’s because trading, not investing, makes up most of Goldman’s business, and Goldman is known as a place where executives achieve mind-boggling wealth.

BlackRock is focused on the less lucrative work of investing money for individuals and institutions such as pension plans, endowments and foundations through mutual funds, exchange-traded funds and separately managed accounts. It makes most of its money through management fees rather than by taking positions for itself. On Wall Street, where boring is suddenly better, Fink is the newly minted nerd king.

Still, there are two things that Goldman has, or used to have, that Fink and his BlackRock co-founders — Rob Kapito, 53, Susan Wagner, 48, and Charles Hallac, 46 — covet: a prestigious brand and a permanent spot in the public consciousness.

Pep Talk

On an October afternoon, recognition is very much on Fink’s mind as he prepares to address his 8,900 worldwide employees in one of his quarterly “state of the state” pep talks. The atmosphere crackles inside the company’s seventh-floor conference room in Manhattan, where an oval table and a wall of monitors show live footage of BlackRock offices around the world, giving the place the feel of the White House’s situation room. One end of the table remains conspicuously empty until two young men in blue dress shirts sit down.

“Dude,” jokes a third, seated on a bench against the wall, “you realize Larry’s gonna be sitting right there? Can you handle the pressure?” The two scramble into other chairs.

Moments later, Fink walks in with a slightly sheepish affect and takes his seat.

“Good morning, everyone,” he says, holding a single sheet of paper. “I’m not here to tell you we’re perfect. We have problems, as all firms do.”

Talking Points

He talks about BlackRock’s quarterly performance (“We grew by 9 percent”); the company’s recent, slightly troubled integration of Barclays Global Investors, the U.K.-based money manager BlackRock bought for $15.2 billion in 2009 (“It’s clear to me that we have a firm that’s more cohesive than ever”); and the current share price (“I think the market is dead wrong in terms of where our stock is trading”).

The rhetoric is hardly soaring, but Fink exudes confidence. He tries to excite his audience with descriptions of the firm’s success and power and the need for all employees to try harder.

“We have a giant responsibility,” he says. “We have to not just focus on $3.4 trillion of assets being managed, but who we’re managing for — maybe it’s your parents, maybe it’s a school teacher or a fireman.” The company is “connected to the entire world in what we do.

Finally, Fink returns to one of his favorite themes, an issue that drives him and keeps him awake at night: the chronic underappreciation of his company.

Risk-Management Skills

“We need to continue to build the BlackRock brand,” he says. “And, hopefully someday, your families will know what BlackRock is.”

As the financial crisis turned the Wall Street power structure on its head, BlackRock offered something valuable — the ability to analyze risk, especially bond risk and mortgage- bond risk. The company had been collecting data on mortgages since 1994, when the market was much smaller than it is today.

Suddenly, the possession of all this information made BlackRock important beyond its size. As bank executives and government officials woke up to the horror of toxic mortgage debt hiding on balance sheets around the world, BlackRock was one of the few entities that could actually figure out what the stuff was worth — and could do so without presenting a competitive threat.

Bailout Backup

“Expertise would have been irrelevant without the trust,” says Terrence Keeley, a former managing director of UBS AG, which hired BlackRock to analyze a $22 billion portfolio of debt that it later sold to the firm. The company helped the U.S. Treasury Department and the Federal Reserve with the government- backed buyout of Bear Stearns by JPMorgan Chase & Co. as well the bailouts of American International Group Inc., Citigroup Inc., Fannie Mae and Freddie Mac.

BlackRock was also lucky, because asset-management firms have barely been affected by the new post-crisis regulations that are causing terror across boardrooms.

While it made its share of mistakes before and after the crisis — including significant losses in funds that invest in real estate and mortgage-backed securities — the company has only gained power and prestige since 2007 and this year is expected by analysts to earn almost $2 billion on $4.7 billion of revenue.

Last year, Fink was one of the highest-paid chief executives on post-bailout Wall Street, with $15.9 million in compensation, according to data from the Securities and Exchange Commission, while Goldman CEO Lloyd Blankfein got $862,657, down from $41 million in 2008.

Acquiring Stature

One of the ways BlackRock became so huge — swamping its nearest competitors, State Street Corp. and Pacific Investment Management Co. — was by swallowing other companies. In 2004 it purchased State Street Research & Management (no relation to State Street) for $375 million from MetLife Inc.; two years later it acquired Merrill Lynch & Co.’s investment unit for $9 billion, bringing its assets above the $1 trillion mark. In February, while BlackRock was digesting Barclays Global, it filed paperwork with the SEC reporting stakes of more than 5 percent in 1,800 companies, temporarily paralyzing the SEC’s electronic database.

As it expands its reach into equity and bond markets around the world, the company wants to introduce its own trading platform, which would help BlackRock match buy and sell orders to save money for clients, reducing its dependence on Wall Street brokers and cutting the fees it sends to them each year. BlackRock has also started a capital markets unit to help its customers invest directly in corporate debt offerings, which will allow it to negotiate better terms.

Massachusetts Pulls Money

“With $3 trillion-plus in assets, it’s safe to assume BlackRock can pull it off,” says Marc Irizarry, an analyst at Goldman Sachs in New York.

BlackRock recently has been in the headlines for the wrong reasons: On Dec. 7, the Massachusetts state pension fund pulled $1 billion from the company, citing dissatisfaction with its performance and the departure of key executives. Investors withdrew $64 billion from the company’s funds in the first half of this year, and BlackRock’s shares have plummeted 26 percent.

There are those who say BlackRock, as with Goldman Sachs before it, has too much sway over the financial system. Others suggest that its ascent is part of an inevitable reshaping of Wall Street.

Buyers’ World

“The balance of power has shifted generally to buyers as opposed to sellers, and people like BlackRock, who control large investment funds, will find themselves in a position of power,” says Peter Solomon, a former vice chairman of Lehman Brothers Holdings Inc. who now runs his own New York investment bank. “What they do with that power would be worth noting. You see the White House calling them, and I can guarantee that they’re not totally passive with their influence.”

When BlackRock rearranged its offices earlier this year, expanding onto several additional floors on East 52nd Street, Fink decided not to radically redecorate his new space. “Same furniture, exactly the same maker,” he says, gesturing around the room and chuckling. No $2 million renovation? “No. I don’t believe in that.”

Still, the surroundings are hardly shabby. In addition to the L-shaped desk sprinkled with family photos, there are potted orchids, shelves of books displayed like trophies and paintings from Fink’s personal collection of American folk art on the walls. He and his wife, Lori, have three children and live primarily in Manhattan, although they also own homes in North Salem, N.Y., an hour north of the city, and Aspen, Colorado.

Discounting Goldman Comparison

Perched on a cream-colored armchair in his office, Fink is a disarming presence. Leaning forward with elbows on knees, his face reacting to questions with cartoonishly exaggerated expressions, he’s less like a master of the universe than a master of the water cooler — albeit one who discourses on unemployment rates and the intricacies of quantitative easing.

He brushes off the Goldman Sachs comparison. “They’re in such a different business,” he says. “I don’t want to be in that business.”

But the recent history and fates of the two companies are inextricable. BlackRock raised $126 million in an initial public offering, to little fanfare, in September 1999 — the same year Goldman staged its own $3.7 billion IPO. Eleven years later, BlackRock’s stock is up 1,110 percent, compared with a 200 percent increase for Goldman. Fink is a warmly received guest of politicians and policy makers in Washington, some of whom wouldn’t risk being caught chumming around with Blankfein.

A Little Fearsome

“I think in some cases, people could be a little frightened of us,” Fink says. “Goldman Sachs is a great partner of BlackRock’s, and yet we compete bitterly against each other, too, in the asset-management side. We use them as a counterparty, and we do a lot of trades with them.” But, he says, “we are very different. This is who we want to be.”

Proprietary trading helped banks rake in enormous gains during the stock market boom that peaked in October 2007. Fink said BlackRock shouldn’t use its balance sheet for anything but co-investments alongside investors, a distinctly un-Goldman-like strategy. He says he rejects the idea of expanding BlackRock’s reach by moving closer to an investment bank or securities firm approach.

“Wall Street’s about velocity of money,” Fink says. “And as velocity of money became more and more important, relationships became less and less important, and as Wall Street started to realize they could make more money by ‘balance sheeting’ things, it became less client-centric.” He says, “I wanted to do something different, and that was being client-centric.”

Lobbying Lawmakers

One consequence of BlackRock’s prominence is that, like Goldman Sachs, the firm has to work to avoid the perception of arrogance. As implementation of the financial reform bill is being worked out by various regulatory agencies in Washington, BlackRock, in what seems like an audacious move to people including Janet Tavakoli, has lobbied to be excluded from the definition of a “systemically important” firm to avoid more stringent regulatory oversight, arguing that it does not have balance sheet risk.

“When you’re big enough, you do pose a systemic risk. Like Fannie and Freddie, their portfolios are so large, any move they make moves the market,” says Tavakoli, a structured-finance consultant. “BlackRock can’t have it all ways, and so far they’ve escaped without so much as a whisper about their reputation, which right now isn’t looking too good from where I sit.”

Bank of America

BlackRock has also proven that it won’t be shy about confronting the world’s biggest financial institutions to defend its turf. In October the company was part of a group including Pimco and the New York Federal Reserve that sent a letter to Bank of America Corp., then BlackRock’s biggest shareholder, seeking to force the bank to repurchase soured mortgages packaged by its Countrywide Financial unit into $47 billion of bonds. Bank of America reduced its stake in BlackRock from 34 percent to about 7.1 percent as federal regulators pushed it to improve its balance sheet. Fink refuses to discuss the demand letter, except to say that his firm has a duty to ensure that the securities purchased on behalf of BlackRock’s clients are what the bank claimed they were.

None of the controversy surrounding the company prevented it from effectively becoming an adjunct of the U.S. government. As the financial system creaked under the weight of toxic mortgage debt in 2007, Fink and other BlackRock executives became regular sounding boards for Timothy Geithner, then chairman of the Federal Reserve Bank of New York, and Federal Reserve Chairman Ben Bernanke. Both have remained in regular contact with Fink, according to phone records made public by the agencies.

Calling for Help

BlackRock’s first assignment came as the subprime-mortgage collapse triggered withdrawals from a money-market fund managed by the Florida Local Government Investment Pool. BlackRock was chosen over JPMorgan, Goldman Sachs and Barclays Plc to salvage the fund by separating the good assets from those that couldn’t be sold, for a $125,000 fee.

As Bear Stearns fell apart in March 2008, JPMorgan CEO Jamie Dimon had a BlackRock team of 50 analysts work through the weekend to evaluate Bear Stearns’s most illiquid assets. At the end of the weekend, Geithner called Fink to ask him to manage $30 billion in bad mortgage debt that had been carved out from Bear Stearns’s books before its healthier parts were sold to JPMorgan. BlackRock played a similar role with AIG, Fannie Mae and Freddie Mac.

The fees that BlackRock earns from these assignments were disclosed last year after Republican Senator Chuck Grassley of Iowa and others expressed outrage over the lack of competitive bidding in the awarding of the government contracts and the potential for conflicts of interest. BlackRock is set to earn at least $120 million from the Fed over a three-year period.

Dual Role

In July, Grassley reiterated questions about the dual role of BlackRock in advising the Federal Reserve and being one of the eight investment firms selected to buy assets under the Public-Private Investment Program. In a letter to Neil Barofsky, the special inspector general of the Troubled Asset Relief Program, Grassley asked the auditor about any findings the agency has made about potential conflicts of interest.

While BlackRock was advising the government on the value of some toxic assets, it and other firms such as Pimco were buying similar securities through their investment units. The company also drew $3.8 billion from the Fed’s Term Asset-Backed Securities Loan Facility, or TALF. The firm has repaid all but $221 million of the funds to the government. BlackRock used the program to give its fund clients the investment opportunity, said Bobbi Collins, a spokeswoman for the firm. Its investment funds don’t have access to information that isn’t publicly available and that it has procedures in place to wall off its advisory and fund units, she said.

Original Idea

“If it were a calmer period, would there have been a better process? Maybe,” says Fink. “We were in these moments where four hours made a difference. I would like those people who criticize to have been there to witness what was going on at that time.” He says, “This could be some of my hubris, but I believe we might have been the only firm that could have done it.”

BlackRock was born in 1988 out of a concept that’s obvious now but was somewhat novel at the time: risk management is crucial. “I think we caught an idea before people recognized that it was an important idea,” Fink says. “We believe that fully understanding what you’re investing in is very important.” Asked where this lightning bolt came from, Fink laughs and says: “Losing money.”

California Guy

Fink grew up in Van Nuys, California, the son of a shoe salesman and an English professor. He attended the University of California, Los Angeles business school before joining First Boston — now part of Credit Suisse Group AG — where he traded bonds in the 1980s. His work slicing and pooling mortgage bonds, then selling them to investors as securities called collateralized mortgage obligations, has today mushroomed into a $2 trillion market. Fink’s department became the most profitable at First Boston, and at 31 he was made the youngest-ever managing director at the firm, as well as the youngest member of its executive committee.

His rise ended abruptly in 1986, shortly after his 33rd birthday. During the first quarter, an investment he’d made had resulted in a $100 million profit; the following quarter, his division lost more than $100 million as interest rates fell unexpectedly. Fink says he became a pariah.

“I knew intellectually how much risk we were taking, but I didn’t have the tools to truly understand it,” he says. “We were loved when we made the hundred-plus million dollars the first quarter; they hated us when we lost $100 million.” He says, “We should have been fired for making all the money and not understanding how we were making it! It was a big lesson, at 33 years old.”

Blackstone Backing

He left First Boston under a cloud less than two years later and started BlackRock with Schlosstein, a former Lehman trader. The firm began its life in the headquarters of its first financial backer, Blackstone Group LP, which gave BlackRock a $5 million line of credit for a 40 percent stake. The fledgling firm’s mission was obscure but simple: to help investors understand the risks in their bond portfolios. “In April of 1988, people would say, ‘Risk management for bonds?’ They looked at us like we were crazy,” says Susan Wagner, who joined the firm at its inception and is now a BlackRock vice chairman. “Today, that model has been validated.”

The firm accumulated about $20 billion in assets by 1994. While business was picking up, the relationship between BlackRock and Blackstone became tense. Fink had a falling out with Blackstone co-founder Stephen Schwarzman that same year over BlackRock’s independence, resulting in the sale of BlackRock to PNC Financial Services Group Inc. of Pittsburgh for $240 million.

GE Breakthrough

The real breakthrough for the company came in 1995, when it helped General Electric Co. value and dispose of a $10 billion portfolio of distressed mortgage securities, saving $1 billion for GE and establishing BlackRock’s reputation. By 2000, Fink saw a chance to build out the firm’s analytics into a separate business, called BlackRock Solutions. The unit offers a risk- management system called Aladdin and now employs more than 800 people with degrees ranging from economics and engineering to mathematics and nuclear physics.

Aladdin can analyze stocks, bonds and derivatives, though what makes it particularly valuable is the work it can do on mortgage-related bonds, the area that Fink helped develop in the 1980s. The system categorizes and assigns a value to each mortgage bond in an investor’s portfolio based on location, Zip Code and dozens of other criteria, says Charles Hallac, a co- founder and the head of BlackRock Solutions, which accounts for about 5 percent of the firm’s fees.

Power of Aladdin

On a green-and-white computer screen on his desk, he demonstrates what clients see when they log into the Aladdin system: the value that BlackRock has assigned to each individual security they’ve invested in, while modeling the value of the security for scenarios such as a repeat of the 2008 credit crisis, a falling U.S. dollar or the breakout of an Asian flu pandemic. As the financial crisis worked its way through the system, Aladdin was a big reason why BlackRock was summoned by governments and financial institutions around the world.

By 2008, BlackRock had started moving away from the riskiest bonds two years before and came through the worst market since the Great Depression without posting a loss, although not all of its investors fared as well. The firm managed to squeeze out a profit of $54 million in the last quarter of 2008, as the collapse of Lehman Brothers and the ensuing market paralysis shocked Wall Street. This put the company in a good position to pounce on Barclays Global, a deal that was hatched by Fink lieutenant Rob Kapito at a Yankees game.

Missteps Taken

Goldman Sachs, meanwhile, lost $2.1 billion in the last three months of 2008, its first-ever quarterly loss. The investment bank also accepted $10 billion in bailout funds from the U.S. government that year.

BlackRock isn’t immune to outside forces. Investors in the preferred shares of its closed-end funds saw their investments frozen as the auction-rate market collapsed in 2008. Some distressed-debt strategies, created before the market meltdown, sank millions of dollars into loans that continued to lose value as markets tanked. And for all its expertise in evaluating fixed-income assets, BlackRock’s own long-term track record in the area has been mediocre. In the three years ended Sept. 30, funds representing only 55 percent of BlackRock’s fixed-income assets had beaten their respective benchmarks.

CDO Losses

“BlackRock had a bit of a stumble in their bond funds in 2008, as there was a failure to anticipate that the global unwind would take out everything except government bonds,” says Eric Jacobson, a Morningstar Inc. fund analyst in Chicago. “I think the lesson they and many others learned is that ultimately, despite a good risk-management system, it’s the quality of active management that will carry you to the next step.”

Critics such as Tavakoli also say that BlackRock’s dismal performance as a manager of certain collateralized-debt obligations during the height of the real estate bubble raises questions about whether the company should be trusted with massive amounts of government assets. According to Tavakoli’s research, several deals worth billions overall that BlackRock put together went bust; problems in the mortgage market were already evident, and financial institutions were scrambling to keep the securitization money train running by executing deals that were sure to fail.

“When I look at their track record with CDOs, I think there were gravely serious questions,” she says. “They’re too close to the problem to merit getting any no-bid contracts” from the government.

Stuyvesant Town

“Given the magnitude of the Great Recession and the corresponding collapse in real estate markets, we are disappointed with the return experience of CDOs with real estate exposure,” Collins, the BlackRock spokeswoman, says.

The company had about $9.6 billion in CDO assets as of Sept. 30 of this year. Fink says he thinks the government will end up making money on the toxic AIG and Bear Stearns assets BlackRock managed.

In one of the company’s most public humiliations, it also lost money in Stuyvesant Town-Peter Cooper Village, a Manhattan apartment complex acquired by in 2006 by BlackRock’s real estate unit and Tishman Speyer Properties LP. One of BlackRock’s investors, the California Public Employees Retirement System, lost $500 million on the deal, prompting Fink to personally apologize to the board of the state pension fund.

“For the clients for whom we made mistakes, we’re guilty,” Fink says. “It still gnaws at me that we failed them.”

‘Swoosh’ Recovery

Back in his office, Fink is less than dire about the future of the teachers and firefighters whose causes he likes to publicly champion.

“I’m much more constructive than the consensus,” he says, “I never felt the economy was going to have this V shape; I always talked about the swoosh economy. And that’s what it is. It’s still the Nike swoosh economy. At the end of the swoosh it goes up. It’s just a longer swoosh part, and that’s where we are.”

How far he rides that swoosh is a question of increasing importance, and the subject of much speculation. Fink says that the time is coming when he won’t run BlackRock. He aspires to someday enter public service if the right opportunity presents itself, though he isn’t specific about what that opportunity might be. As he ruminates on the future, he jumps up to fetch a blue binder from his bookshelf.

“We do a 360 review of every leader,” he says, opening the book. “This is really intense stuff.”

He starts to read an anonymous comment contributed by another BlackRock executive: “Overall, I’d give Larry a 96 out of 100,” he begins. Then, “I worry about Larry. I love that he’s client focused, but one day he’s going to keel over. In flying all around the world, he insists on taking commercial transportation. We should probably get him a plane.”

To contact the reporters on this story: Sheelah Kolhatkar in New York at skolhatkar Sree Vidya Bhaktavatsalam in Boston at sbhaktavatsa

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel .

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Large Hedge Funds Riskier Than Perceived, Spring Mountain Says

Nov. 11 (Bloomberg) — Investors who believe larger hedge funds offer more safety and better returns than their smaller rivals may be misguided, according to Spring Mountain Capital LP.

Funds with more than $1.5 billion in assets generate an average of 0.2 percent a month less in alpha, or returns above market indexes, than smaller managers, the New York-based investment management firm said today in a report. Spring Mountain analyzed 7,545 existing and 8,916 closed funds from 1995 through this May.

To contact the reporter on this story: Kelly Bit in New York at kbit

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel

To read full article click here.

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EU Parliament Ratifies Rules for Hedge-Fund Managers

Nov. 11 (Bloomberg) — Hedge-fund and private-equity regulations that restrict bonuses and require increased disclosure at the firms were approved today by European Union lawmakers in Brussels.

The European Parliament voted 513 to 92 in favor of the rules after negotiators representing the parliament and 27 member states reached a preliminary deal last month.

Finance ministers from the EU agreed on a compromise at a meeting in Luxembourg in October to give the European Securities and Markets Authority powers over a so-called passport system for non-EU hedge-fund managers. The Brussels-based European Commission had proposed the rules last year.

To contact the reporters on this story: Ben Moshinsky in Brussels at bmoshinsky

To contact the editors responsible for this story: Anthony Aarons at aaarons

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UBS in Talks With Prop Traders Mulling Hedge Funds

Oct. 15 (Bloomberg) — UBS AG, the largest Swiss bank, said it has been in talks with “dozens” of proprietary traders from firms worldwide who may start their own hedge funds as banks seek to comply with new U.S. rules aimed at curbing risk.

Prime brokerages provide services such as cash and securities lending, custody, introduction to potential investors and startup consulting services to hedge funds.

To contact the reporter on this story: Netty Ismail in Singapore nismail3

To contact the editor responsible for this story: Andreea Papuc at apapuc1

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Swaps Show Hu Jintao Bonds Approaching Treasuries: China Credit

Oct. 11 (Bloomberg) — At a time when governments around the world are facing growing debt, China’s bonds are becoming almost as safe as U.S. Treasuries in the market for insuring against defaults.

China’s bonds have become cheaper to insure than those of the U.K. and France since August as the fastest-growing economy surpassed Japan to become the world’s second-largest. Moody’s Investors Service said last week it may raise China’s debt rating from A1, five levels below the top Aaa grade.

Foreign-Exchange Reserves

The government of Chinese President Hu Jintao controls the world’s biggest holdings of foreign-exchange reserves, with about $2.5 trillion, including at least $846 billion of U.S. Treasuries, according to data compiled by Bloomberg. Government debt will amount to 22 percent of GDP this year, compared with 94 percent in the U.S., 85 percent for France and 82 percent in the U.K., according to IMF forecasts.

Five-year credit-default swaps protecting U.K. government debt cost 60 basis points on Oct. 8, up 13 during the past year. Contracts tied to France trade for 76 basis points, up from 22 a year ago, according to CMA.

To contact the reporter on this story: Shelley Smith; in Hong Kong at ssmith118

To contact the editor responsible for this story: Will McSheehy at wmcsheehy

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Hedge Funds Rebound Near Pre-Crisis Levels With September Gains

Oct. 7 (Bloomberg) — Hedge funds rose 3.4 percent in September, the most since May 2009, bringing them close to their peak before the financial crisis, Hedge Fund Research Inc. said.

September gains in the HFRI Fund Weighted Composite Index, which tracks more than 2,200 hedge funds, reflect a surge in global equity markets, the Chicago-based research firm said today in an e-mailed statement. Stocks worldwide advanced 9.1 percent in September, the best month in more than a year.

Funds of hedge funds increased 2.4 percent in September, also the strongest gain since May 2009.

To contact the reporter on this story: Kelly Bit in New York at kbit

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel

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Fed to Cut Outlook, Europe Risks Grow, El-Erian Says

Sept. 20 (Bloomberg) — The Federal Reserve will cut its growth forecasts and Europe’s economic bailout is failing, said Mohamed A. El-Erian, chief executive at Pacific Investment Management Co., which runs the world’s biggest bond fund.

U.S. central bankers may wait beyond their meeting tomorrow to announce additional steps to sustain the expansion, El-Erian wrote in an opinion piece on Pimco’s website. Slower-than- expected economic growth has fueled speculation the Fed will expand its program of Treasury purchases as it tries to keep borrowing costs low. Industrialized nations are eager to let their currencies weaken to aid their economies, he said.

The Fed will signal new easing measures, “but probably not at this meeting,” wrote El-Erian, who is based in Newport Beach, California. “It should and, I suspect, will,” reduce its growth projections.

Fed Chairman Ben S. Bernanke may need time to decide if additional stimulus is needed to support a rebound in growth, say economists surveyed by Bloomberg News. Economic woes are spreading to Europe, where Irish bonds led declines last week by the debt of so-called peripheral euro-region countries on concern the nation’s banks will require further government aid.

The Fed will affirm its pledge to keep interest rates low for an “extended period” and maintain the floor on its holdings of securities, say economists surveyed by Bloomberg News before the meeting tomorrow.

Europe Concerns

Concerns about Europe’s solvency are intensifying, pushing up risk measures for Greece, Ireland, Portugal and Spain to “at or near danger levels,” El-Erian wrote in his piece, which was first published yesterday on ft.com’s ftalphaville website section. “The failure to reduce risk spreads means that the public sector bailout is not working.”

Contracts insuring against default on Ireland have climbed to 422 basis points, according to data-provider CMA, the most since the data started in 2008. The figure is almost 10 times the cost for protecting U.S. debt.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A basis point on a credit-default swap protecting 10 million euros ($13 million) of debt from default for five years is equivalent to 1,000 euros a year.

Debt Crisis

Europe’s sovereign debt crisis took hold at the end of 2009 after a new government in Greece said the budget deficit was twice as big as the previous administration disclosed. In April, Greece asked to tap an EU-International Monetary Fund 110 billion-euro loan facility after being shut out of debt markets.

Germany’s biggest bond dealers say the worst is over for the region’s most-indebted nations.

Yields on government bonds of Greece, Spain, Ireland and Portugal will fall to within 2.2 percentage points of benchmark German bunds on average within the next two years from 4.61 percentage points last week, according to a Bloomberg News survey of 15 banks that trade directly with Germany’s debt agency. HSBC Holdings Plc, Europe’s largest bank by market value, Goldman Sachs Group Inc. and Societe Generale SA advise buying securities sold by Greece.

Austerity Measures

Bond dealers are confident that austerity measures will be enough to damp speculation the 16-nation currency union is in jeopardy of falling apart. Gross domestic product in the region will likely increase 1.7 percent this year instead of the 0.9 percent projected at the depth of the crisis in May, the European Commission said Sept. 13. Banks were given more time to raise capital levels to meet new regulations, reducing the likelihood they will need additional government aid.

“All the policy backstops have put a floor under the downside risks for peripheral euro-region bonds,” said Michael Vaknin, a senior fixed-income strategist in London at Goldman Sachs, which didn’t participate in the survey. “Spreads are near their records, but the EU and International Monetary Fund have pledged their support and opportunities are starting to emerge.”

Greece, Ireland and Portugal have the most expensive credit-default swaps of 21 bond markets tracked by Bloomberg data.

“It raises the risk of renewed contagion,” El-Erian wrote.

The record $248 billion Pimco Total Return Fund managed by Bill Gross returned 8.6 percent this year, beating 77 percent of its peers, according to data compiled by Bloomberg.

Pimco, which managed more than $1.1 trillion of assets as of June 30, according to its website, is a unit of Munich-based insurer Allianz SE.

To contact the reporter on this story: Wes Goodman in Singapore at wgoodman .

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Citadel Said to Consider Fee Cuts as Hedge Funds Seek Clients

Sept. 17 (Bloomberg) — Citadel LLC is considering cutting fees on its two main funds as it attempts to attract clients during the worst climate for raising money in two decades, said two people with knowledge of the firm’s plans.

The Kensington and Wellington hedge funds at Chicago-based Citadel, the $11.1 billion firm founded by Ken Griffin, are among a handful that pass along all expenses to clients rather than charging the industry-standard 2 percent annual management fee. Expenses at the firm have reached as much as 8 percent of assets, and typically range from 4 percent to 6 percent.

Citadel lost 55 percent of assets as markets tumbled in 2008, and when investors sought to take out $1.2 billion the firm suspended redemptions before restoring them in late 2009. Even after last year’s 62 percent return and this year’s 4 percent gain, the funds would still need to climb about 30 percent to make clients whole. Assets fell from $13.5 billion a year ago as money was returned to customers.

“Investors will never forget how Citadel acted in 2008,” Brad Alford, who runs Alpha Capital Management LLC in Atlanta, said in an interview. His firm farms out money to hedge funds and is not a Citadel investor.

Citadel also may make it easier for clients to withdraw money from their funds, said the people, who asked not to be named because the information isn’t public. Some investors in the two funds can take out money quarterly, subject to restrictions. Other clients are subject to longer lock-ups.

Devon Spurgeon, a spokeswoman for the firm, declined to comment on the possible changes.

The industry saw about $286 billion in net withdrawals in 2008 and 2009, according to Chicago-based Hedge Fund Research Inc. Funds collected a net $23.3 billion in the first six months of this year, data from Hedge Fund Research show.

Barring a record windfall of new cash in the second half, the industry will endure its first three-year period of net redemptions since the firm started tracking trends in 1990.

To contact the reporters on this story: Saijel Kishan in New York at skishan Katherine Burton in New York at kburton

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