Pimco's power play
Bill Gross is deftly navigating the most treacherous market in modern times. But is the bond king too big? Does he have Washington - and us - over a barrel?
301 Moved Permanently
(Fortune Magazine) -- On the wall of his office overlooking the Pacific Ocean, Bill Gross has hung a poster of Jesse Livermore. In the early decades of the last century Livermore made and lost several fortunes on Wall Street before killing himself in 1940. Alongside the picture is an adaptation of a quote from the deceased: "An investor has to guard against many things and most of all against himself."
It's a warning that Gross, 65, founder and co-chief investment officer of Pimco, the world's largest and most influential bond investment house, says he thinks about a lot these days as Wall Street legends all around him lose their money and reputations. "Human nature means that institutions at some point lose their sense of mission," he says. "That sense of vulnerability drives Pimco."
So far Gross and Mohamed El-Erian, 50, who serves as both CEO and co-CIO, have deftly navigated the most treacherous bond market in memory. Thanks to enormous bets on mortgage bonds backed by Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), Pimco had an outstanding year. Total Return, the firm's flagship mutual fund, earned 4.8% in 2008 while the typical intermediate-term bond fund lost 4.7%, according to Morningstar. That gain, plus investor inflows of $14 billion, help cement Total Return's position as the world's largest mutual fund, with $132 billion in assets (as of Jan. 1). Pimco, which since 2000 has been a subsidiary of German financial conglomerate Allianz (AZ), now manages $747 billion in assets.
But Pimco is much more than just a big bond house. For one thing, it has become the U.S. government's partner in reviving the credit markets. It runs the Federal Reserve's $251 billion commercial paper program, which keeps short-term loans flowing to corporate America. It is also one of four asset managers picked to run the government's $500 billion program to purchase mortgage-backed securities.
With many traditional bond market players - like investment banks, insurers, and pension funds - on the sidelines, Pimco is serving as a buyer of last resort for hedge funds and others seeking to sell bonds to raise cash. "They don't want to, and often can't, sell their bond portfolios in bits and pieces," says El-Erian, "but we are big and liquid enough to buy the entire thing." Pimco also will be among the few institutional investors able to soak up the coming onslaught of Treasuries, as well as mortgage paper backed by Fannie Mae and Freddie Mac, and municipal bonds.
In short, thanks to the missteps of its rivals as well as its own success, Pimco has become essential to the functioning of the credit markets - and the revival of the economy. "If Pimco didn't exist, the government would have to create it," says Paul Kedrosky, a senior fellow at the Kauffman Foundation and a strategist with institutional money management firm Ten Asset Management. "It needs an entity that can provide the market liquidity that Pimco can provide." Gross is well aware of his firm's special status. "Our role now is to make money for Pimco, but it is also much greater," Gross tells Fortune. "We efficiently allocate capital around the U.S. and the world. We are in the business of capitalism."
Not everyone is comfortable with Pimco's growing power and prominence. Peter Cohan, a venture capitalist and management consultant, says he's concerned that Pimco may have too much sway over Washington and be in a position to dictate policy choices that might be good for Pimco but bad for taxpayers. "This is a bilateral monopoly with one big seller and one big buyer," he says. "Gross, a famously good gambler, knows that winning in this type of market means threatening not to buy when the government needs to sell. Gross has the government in a weak negotiating position."
Josh Rosner of research firm Graham Fisher is not happy with Pimco's dual roles as private investor and manager of government bailout programs. "Gross is a deeply conflicted player given undue sway in matters of public interest that are potentially at odds with his positions."
Indeed, Pimco's success stems from shrewd bets on government intervention. Rewind the clock to May 2004, when Pimco managers gathered at the firm's Newport Beach, Calif., headquarters for an annual brainstorming event called the Secular Forum. It's an opportunity to hear outside speakers and develop macroeconomic theses that will determine investment strategies for years to come. At the 2004 session a view emerged that although the world looked calm, the economy was being fueled by an unsustainable borrowing binge. At some point it would have to end, and this so-called deleveraging process would trigger an economic storm, beginning with housing and financials. Ultimately the government would have to step in to ease the pain.
That vision of the future has guided Pimco's investments - though not even Gross and company foresaw just how big Uncle Sam's role would become. For example, in 2008 Gross shifted from Treasuries and corporate bonds into mortgage debt backed by Fannie and Freddie because he believed that the government would ultimately keep those government-sponsored enterprises (GSEs) afloat. By May, Gross had moved 60% of Total Return into GSE-backed bonds, up from 20% the year before. "In a way, we've partnered with the government," says El-Erian. "We looked for assets that we felt the government would eventually have to own or support."
Pimco also made a bet on GMAC, the struggling finance arm of General Motors (GM, Fortune 500), reasoning that Washington would not let the lender fail for fear of crippling the U.S. auto industry. "We tried to move ahead of the government," says Gross, "to purchase assets before we believe they will have to."
Once the financial crisis hit, Gross was not shy about calling for a bailout - and he is an especially effective advocate for his causes. Where many big money managers try to keep a low profile, Gross has always maintained a forceful public persona, making regular television appearances to promote his views. An excellent writer, he delivers influential market commentaries on the Pimco website and in newspapers and magazines (including Fortune).
In a Pimco newsletter published on Sept. 4, 2008, for example, Gross wrote: "We, as well as our sovereign wealth fund and central bank counterparts, are reluctant to make additional commitments" to troubled companies unless the Treasury essentially guarantees their solvency. Later that day Gross made the same argument to CNBC's Erin Burnett. "You can say that I'm talking my book," Gross told Burnett.
On Sept. 7, three days after Gross's CNBC appearance, the government placed Fannie and Freddie under conservatorship. That move trashed Fannie and Freddie's common and preferred equity but provided a huge boost to their bonds - and to Pimco. The Total Return fund jumped 1.3%, or $1.7 billion.
Well, money managers often make statements that would help their investments. But a number of critics contend that Gross was giving the government an ultimatum. "He convinced the Treasury to keep his bonds from going to zero, or else he would stop lending money to distressed companies dthat were important to the economy," Cohan says. The U.S. government will need to raise lots of capital to fuel efforts to end the recession. That will mean issuing lots of bonds. Since Pimco is one of the few buyers capable of absorbing such vast amounts, Washington "can't afford to let him walk away," says Cohan. "The government should recognize that just as some institutions are too big to fail, Pimco is too big to talk its book," says Rosner. He thinks that the government should have clipped bondholders as well as shareholders when it took over Fannie and Freddie.
The case of GMAC also raises questions about Pimco's power. Last fall GMAC executives applied to make GMAC a bank holding company so that it could access federal funds. Before they would approve the move, federal regulators insisted that 75% of GMAC's bonds be swapped for equity to shore up the company's capital base. Offering 60 cents on the dollar, GMAC was able to buy 59% of its bonds. But Pimco, which held a big chunk, refused the deal. The government blinked, allowing GMAC to become a bank holding company in late December even though it hadn't met the 75% threshold. After the conversion, GMAC bonds rose in value; Pimco says it plans to hold them to maturity.
Are the criticisms fair? Is Pimco simply pursuing selfish goals in the guise of aiding the markets? Gross thinks for a long time before addressing that question. "If you're in a marriage, each person has his or her own concept of what the argument is about. That's because they perceive reality differently, and not always because one is right and the other is wrong," he says. "The policy prescriptions I've proposed were a realistic attempt to assist the markets. In my eyes, they had nothing to do with bailing out our positions."
And to be sure, many economists and bankers agree with Gross's view that a failure at Fannie or Freddie would have had disastrous effects, spreading more pain throughout the housing markets and the asset-backed securities market, and hitting China, a huge holder of Fannie and Freddie debt, and other central banks. And as far as Pimco's participation in federal bailout programs goes, Gross says he has no contact with the Pimco employees managing government money.
Gross is not about to pull in his horns. He says that he has been criticized within the firm for his numerous television, radio, and print appearances. But, he says, he speaks out because he believes in his ideas. And he, El-Erian, and other Pimco executives are still on the stump, talking up the mortgage market. In the pages of the Wall Street Journal, on Bloomberg, and on CNBC, they have recently said that the government should buy mortgage-backed securities and agency debt rather than long-dated Treasuries, as the Treasury officials have proposed. They've also supported the idea of the government's buying bad assets from banks. These opinions support the firm's book: Pimco still has a huge position in GSE-backed mortgage debt, as well as the preferred stock and debt of big banks. But that doesn't make the views wrong.
As with other aspects of this financial crisis, we seem to be in uncharted waters here. Rarely, if ever, has one firm occupied such a pivotal role in the nation's financial system; but rarely has the system been in such distress.
Some critics, of course, may simply be envious of Pimco's success. "It could be a case of attacking the leader," says Lawrence Jones (See correction), the Morningstar analyst who covers Pimco.
For his part, Gross has no illusions that Pimco's recent good fortune is any kind of guarantee. "I do yoga to forestall the inevitable," he says. "I do what I do here at Pimco to forestall it too. But even though I wish we did, no one has license to live forever."