Saturday, July 04, 2009
NY Times: Treasury's Got Bill Gross On Speed Dial
By Devin Leonard
Published June 20, 2009
Every day, Bill Gross, the world's most successful bond fund manager, withdraws into a conference room at lunchtime with his lieutenants to discuss his firm's investments. The blinds are drawn to keep out the sunshine, and he forbids any fiddling with Blackberrys or cellphones. He wants everyone disconnected from the outside world and focused on what matters most to him: mining riches for his clients at Pimco, the swiftly growing money management firm.
Mr. Gross, 65, has long been celebrated for his eccentricities. He learned some of his lucrative investing strategies by gambling in Las Vegas. Many of his most inspired ideas arrived while he was standing on his head doing yoga. He knows he has to be well dressed for client meetings or television - but instead of keeping his Hermes ties neatly knotted, he drapes them around his neck like scarves so he can labor with his collar open.
With the collapse of Wall Street, Mr. Gross has emerged as one of the nation's most influential financiers. His frequent appearances on CNBC draw buzz, as do his wickedly humorous monthly
investing columns on the Pimco website. Treasury secretaries call him for advice. Warren E. Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.
"He's a very individualistic person. He doesn't come at analysis or investment judgment in the words, terminology or ambience that I have seen to over the decades," Mr. Greenspan says. "That may be the secret of his success. There is no doubt there is an extraordinary intellect there." Mr. Greenspan, it should be noted, now works for Pimco as a consultant.
Amid all of this, Mr. Gross and his firm are trying to shape the government's response to the economic crisis. He is one of the most fervent supporters of the Obama's administration's plan to enlist private investors to help bail out the nation's ailing banks and try to revive the economy.
That effort, known as the Public-Private Investment Program, or P.P.I.P, has gained little traction so far. But Mr. Gross has energetically defended its architect, Treasury Secretary Timothy F. Geithner, against critics like the New York University economics professor Nouriel Roubini and New York Times columnist Paul Krugman - both of whom argue that the strategy is flawed and that it would be best for the government to temporarily nationalize so-called zombie banks to prevent a repeat of the Great Depression.
Such nationalization, Mr. Gross insists, would be an unmitigated disaster. "There are two grand plans," he said this spring at a meeting of his firm's investment committee. "One is the Krugman-Roubini plan. They think the banks have so much garbage they are beyond hope. The other side is the administration's side. That's the one we're on. If the other side should ever gain credence, then we'll have something to worry about."
Mr. Gross is hardly a disinterested observer. Pimco, owned by the German insurer, Allianz, is jockeying to be picked by Mr. Geithner to relieve the likes of Bank of America, Citigroup and other banks of an estimated $1 trillion in soured mortgage debt so they can start lending freely again. Mr. Gross calls the plan a "win-win-win" for the banks, taxpayers, and Pimco investors.
The government is planning to announce soon which money managers will participate. A spokesman for the Treasury Department would not say whether Pimco would be one of them.
In many ways, it is perfectly logical for the White House to turn to someone like Mr. Gross at such a time. Few investors understand the mortgage market better. As co-chief-investment officer, he personally manages Pimco's flagship, the Total Return fund, which has $158 billion in assets. As of the end of May, he had invested 61 percent of the fund's money in mortgage bonds.
Mr. Gross has always been partial to mortgage bonds. And why not? He has done fabulously well with them. In an October 2005 letter to investors, he made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis. Almost everybody ignored him. Today, they wish they hadn't.
When the housing bubble burst and the financial markets fell apart, investors lost billions of dollars. Not Mr. Gross's clients. Class A shares of the Total Return fund, for individual investors, were up 4.3 percent in 2008, or nine percentage points ahead of comparable bond funds, according to Morningstar; this year through Thursday, the shares were up 5.4 percent.
In the midst of an economic crisis, those numbers are impressive. So is the longer-term record: In the 10 years through Thursday, the fund had an annualized return of 6.42 percent, beating its benchmark by 0.54 percentage points, according to Morningstar.
That's one of the reasons the government has courted him closely. Last fall, the Federal Reserve Bank of New York, run at the time by Mr. Geithner, hired Pimco - along with BlackRock, Goldman Sachs, and Wellington Management - to buy up to $1.25 trillion in mortgage bonds in an effort to keep interest rates from skyrocketing.
Last December, when it was pressing Bank of America to complete its ill-fated acquisition of Merrill Lynch, the Federal Reserve also looked for Pimco for advice. According to recently released messages that Fed staff members sent one another that month, Pimco evaluated the two banks and concluded that Merrill wouldn't survive without a capital infusion or additional government aid.
Today, Mr. Gross is eager to buy the same subprime loans he once refused to touch, as part of the Treasury's distressed-asset initiative. After all, the thinking goes, if anybody can figure out how much all this debt is worth, it's Pimco. But Pimco's investment in so many aspects of the bailout has made many other financiers and analysts uncomfortable. They say its proximity to the Treasury Department and the Fed may allow it to reap billions of easy dollars through federal contracts and preferential investment opportunities.
A frequent complaint is this: Why is the Federal Reserve paying Pimco to buy mortgage securities on its behald, when the firm is already a huge buyer and seller of the same bonds. "That's the equivalent of a no-bid contract in Iraq," fumes Barry Ritholtz, who runs an equity research firm in New York and writes The Big Picture, a popular and well-regarded economics blog. "It's a license to steal."
No one, of course, has actually accused Pimco of theft. But there is a larger question: Whose interests is the firm looking out for in the bailout? Money managers, after all, have a legal obligation - a fiduciary responsibility - to put the interest of their investors before anyone else. Even Mr. Gross acknowledges that Pimco's interests won't always be aligned with those of the government.
Mr. Gross points out that he has never even met Mr. Geithner. For its part, the Treasury Department plays down Pimco's influence. "We speak with a number of market participants and believe seeking out a diversity of perspectives is critical to our efforts," says Andrew Williams, a spokesman for the department. He says the Treasury takes conflict of interests "very seriously in all cases."
Mr. Gross is well aware of the criticism that has been directed at Pimco. During an interview at its headquarters in Newport Beach, Calif., sitting at his horseshoe-shaped desk on its 4,200-square-foot trading floor overlooking the Pacific Ocean, he brings up the topic of perceived conflicts of interest himself.
He almost never personally buys and sells bonds. Pimco has dozens of traders who do this for him here. "There's the mortgage desk over there," he says, pointing to a group of well-scrubbed young people hunched over computers. "We've been buying some mortgages this morning. That's our baby, so to speak. That's our bag."
He immediately adds that this mortgage trading operation is completely separate from the one on the floor below, where traders are working on behalf of the Fed. He says he can't even visit that floor himself without a company lawyer at his side. The last time he did was in December, when he wised the traders happy holidays.
"I said, 'Merry Christmas,' " Mr. Gross recalls. "The lawyer said, 'Mr. Gross says Merry Christmas.' Right then and there, I knew that communications were basically severed. That's the way the Fed wants it."
He says he assumes that Pimco traders working on behalf of the government don't talk to their peers trading for Pimco's own accounts. Then again, he said he doesn't know for sure what happens after hours.
"I don't drink beer with these guys; I have no idea what happens in the privacy of their own homes," he says. He says that when he encounters traders working for the Fed outside the office, he doesn't talk to them.
"I pass some of them on the way to the lunch shop," he says. "I just sort of wave. I don't know what to do."
Mr. Gross is fond of saying he is the antithesis of a Wall Street "alpha male." He is every bit the South Californian, with longish hair and a laid-back attitude. Most Wall Street executives won't talk to a reporter without a public relations person hovering around. Even then, they can be disappointingly bland. No one would ever say such a thing about Mr. Gross. He approaches an interview is almost like a therapy session: it is a chance for him to make confessions.
"I'll tell you an interesting story," he says at one point. "I shouldn't, but I will. It's like I'm taking truth serum every time I do this."
The tale is about "a very childish and immature" e-mail message that he sent Don Phillips, a managing director of Morningstar, the mutual fund research company, when Morningstar didn't select him as its fixed-income fund manager of the year in 2008. It is an intriguing story. But it's nowhere near as interesting as what he has to say about Pimco's role in the bailout.
He sounds genuinely pained by the economic collapse. "There was always a big part of me that thought the Depression was just something from my old American Heritage history books," he says. "I thought: 'This stuff can't happen really. I mean, this is just for the economic philosophers and the paranoid worriers.' Then, in the last 6 to 12 months, you go, 'God, this just might happen!' "
With the fate of the largest banks still uncertain, a heated debate continues about how to fix the problem. Mr. Geithner wants to enlist money managers like Pimco to buy distressed bank assets with financial backing from the government. That way, his supporters argue, they can offer such generous prices that banks can disgorge the assets without too painful a hit.
But proponents of bank nationalization say the Treasury's plan won't work because some banks can't afford to take any losses on asset sales. This camp believes nationalization is the best path because it will let the government clean up banks' balance sheets and restore their health.
Mr. Gross argues that this would completely destabilize the financial markets. "If you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B. of. A would do," he argued in one of his monthly letters to Pimco investors.
His mood brightens when he talks about how much money Pimco could reap by participating in the Geithner plan. No wonder: the terms are deliciously favorable for participants selected as fund managers. Money managers like Pimco would be expected to raise at least $500 million from their clients. The Treasury would match that with taxpayer dollars. Then Pimco and the Treasury would create a jointly owned fund of at least $1 billion that would buy distressed mortgage bonds.
Government largess doesn't stop there. The fund will be eligible for low-interest financing from both the Treasury and the Fed that analysts at Credit Suisse First Boston estimate could be as high as four times the total equity in the fund. So if Pimco ponied up $500 million, the fund that it manages could borrow $4 billion.
Pimco would then negotiate with banks to buy their wobbly mortgage-backed securities. Mr. Gross says that some of these securities pay an interest rate as high as 14 percent and that even if default rates were 70 percent, Pimco and the government would still make a 5 percent return after covering their negligible borrowing costs. That means the government-Pimco partnership could make at least $250 million a year on a $5 billion investment fund. Of that amount, Pimco would get $125 million - a 25 percent return on its original investment.
But here's the part that makes Mr. Gross salivate. If things go badly, the government is responsible for repaying all that debt. "It's just like in blackjack," he says. "That puts the odds in your favor. If you don't bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket."
Indeed, for all of Mr. Gross's anguished talk about the crisis, there's no escaping that fact that Pimco isn't exactly suffering. In November, the Total Return fund became the world's largest mutual fund with $128.4 billion in assets, according to Morningstar. Since then, its assets under management have climbed to $158 billion. The firm once had trouble luring prospective employees to Newport Beach. Now Pimco is being deluged with resumes.
Meanwhile, some of the most powerful people in the nation call Mr. Gross for advice. "Paulson will call, Geithner will call, and I'll be like, 'Yabba-dabba' or 'Blah-blah-blah,' " he says with a measure of self-deprecation - and an equal dose of pride. "I turn into a walking, talking idiot."
Mr. Gross has been through crises before. He nearly died - and briefly lost part of his scalp - in 1966 when crashed his car while making a doughnut run for his fraternity brothers at Duke University. He spent much of his senior year recovering in the hospital. He also became obsessed with blackjack after reading "Beat the Dealer: A Winning Strategy for the Game of Twenty-One," by Edward O. Thorp, an M.I.T. mathematics professor (who is not a very successful hedge fund manager).
After he got his diploma, Mr. Gross hopped a freight train to Las Vegas with $200 sewed into his pant leg. He played blackjack for 16 hours a day. "After a while it gets pretty boring and pretty stinky," he recalls. "People lose money. They don't win it. You're just watching the dealers."
Even so, in four months, he turned $200 into $10,000 and used his winnings to pay for his studies toward an M.B.A. at the University of California, Los Angeles. He thought he could apply the lessons learned at the blackjack table to the stock market. After getting the degree, he called all the big Wall Street brokerage firms. Nobody called him back.
Finally, his mother showed him a classified ad for a junior credit analyst in the bond department at the Pacific Investment Management Company, a subsidiary of Pacific Mutual Life.
Although Mr. Gross had no interest in bonds, he took the job as a steppingstone to stock-picking. Back then, the bond market was a sleepy corner of the financial world. Mr. Gross's job was to make sure that Pimco avoided buying bonds from companies that might go belly-up and burn their creditors.
By the mid-1970s, the market had become sexier as shrewd investors like Mr. Gross began trading bonds like stocks - and began earning outsize profits.
In short order, Mr. Gross also dived into the first mortgage-backed securities (which carried comfy government guarantees) and began studiously monitoring interest rates so he could placed bets on his own macroeconomic predictions. This was highly unusual for a bond fund manager - and still is.
"There are a lot of big bond shops that frankly don't feel confident doing this," says Lawrence Jones, a Morningstar analyst. "It's not part of their tool kit."
Mr. Gross played well on television. In 1983, he became a regular on "Wall Street Week" on PBS; he loved the attention, and his ubiquity gave Pimco a big boost. Four years later, Pimco rolled out the Total Return fund. Over the next 10 years, its assets soared to $24 billion from $165 million. Much of this was because of shrewd investing. But TV did wonders, too. "It doesn't do you an good to be good if nobody knows about you," Mr. Gross says.
In 1999, he warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross's fund ended 2000 up 12 percent, and that same year he and his partners sold Pimco to Allianz for $3.3 billion. Mr. Gross received $233 million for his stake, and Allianz also agreed to pay him $40 million in retention bonuses and seems to be giving him free rein.
Not that Mr. Gross was going anywhere.
Free from distraction in a gym across the street from his offices, Mr. Gross happily rides a stationary bike, followed by a half-hour of yoga. Toward the end of his routine, he stands on his head for a few minutes in a position called the Feathered Peacock. He wobbles so much that you expect him to lose his balance and fall over, but he says some of his best ideas have come to him while he was upside down.
One of those insights came in 2005, when - while standing on his head - he began to worry about the real estate bubble.
He'd watched the prices of homes climb into the stratosphere in Southern California, and he says he felt as if he were witnessing something out of "Alice in Wonderland." Was this happening all around the country?
Pimco dispatched 11 mortgage analysts to 20 cities to find out. They posed as prospective homebuyers and drove around with unsuspecting real estate agents and mortgage brokers who told them how easily they could get a home loan. "It was a little deceptive," Mr. Gross says. "I didn't feel good about that, but I didn't know how else to get the real information."
Mr. Gross says he thought it was obvious what was driving this madness: subprime mortgages. He was certain that the real estate would collapse and take the economy down with it, and he made those thoughts known in letters to his investors. Pimco steered clear of risky housing debt, which meant that, for a time, some of his competitors who stockpiled the briefly lucrative products outperformed him.
For a fiercely competitive man, it was an awkward time. "Bill takes it hard when the numbers aren't what he thinks they should be," his wife, Sue, confided by e-mail. "In 2006, he recommended a Pimco bond fund to the owner of a local doughnut shop, and when it didn't do well for a while, he could hardly go in the shop for his favorite coconut cake doughnut."
Fortunately for Mr. Gross, but not for the economy, this couldn't last forever. The housing bubble finally burst in 2007, and the crisis followed. He was vindicated. Yet this was only part of the reason for his success. He also predicted in one of his monthly columns that the government would have to pump billions of dollars into the economy to avery a total collapse. At the same time, he and his Pimco team came up with an audacious plan: invest in bond sectors that Washington would be forced to support - like government-backed mortgages guaranteed by Fannie Mae and Freddie Mac.
Mr. Gross whimsically calls this strategy "shake hands with the government." And he used his access to the news media to get the government's attention. In a CNBC interview on Aug. 20, 2008, he argued that Americans were putting "their money in the mattress" because the government hadn't rescued imperiled financial institutions like Fannie and Freddie.
On Sept. 7, Henry M. Paulson Jr., then the Treasury secretary, announced that the government was taking over Fannie and Freddie. The value of the Total Return fund rose by $1.7 billion in a single day.
Michele David, Mr. Paulson's former spokeswoman, says Mr. Gross's TV appearances had nothing to do with the decision: "There are $5.4 trillion of Fannie and Freddie securities around the world. Investors here and across the globe were worried and voicing the same concerns."
But some of Pimco's critics aren't convinced. "The Treasury Department watches CNBC all day," says Steven Eisman, a portfolio manager and banking expert at FrontPoint Partners, an investment firm. "I know that for a fact. He was putting pressure on them."
Mr. Gross says nothing could have been further from his mind. He says he goes on TV with "a disbelief that people will believe or act on what I say," adding that "people should think independently."
At the same time, Pimco tried to influence the direction of the bailout itself. In the spring of 2008, Pimco's chief executive, Mohamed A. el-Erian, a former policy expert at the International Monetary Fund, floated a plan in Washington for a public-private partnership similar to the P.P.I.P. plan that Mr. Geithner later unveiled. It didn't get much traction.
But then Lehman Brothers collapsed on Sept. 15. Mr. Paulson asked Congress to pass the Troubled Asset Relief Plan, better known as TARP, which would enable the government to spend $700 billion to buy mortgage securities from teetering banks. The Treasury turned to Pimco and others for help.
"When we first asked for the TARP legislation in September, we were looking at purchasing assets," says Ms. Davis, the former Treasury spokeswoman. "We definitely talked to Pimco and a lot of other asset managers. You had to find out how such a program might work and bounce ideas around to see how this thing would work."
In the midst of the crisis, in October, Mr. Gross's friend, Mr. Buffett, wrote to Mr. Paulson suggesting a plan similar to the one Mr. Erian had been pushing. However, Mr. Buffett says he came up with his idea independently.
"I call Bill Gross and Mohamed and said: 'I've got this idea. If it goes forward, I hope you guys would manage it and would do it on a pro bono basis,' " Mr. Buffett recalled in an interview. "Within an hour, they said they were on board and they were willing to do whatever was called for."
Mr. Gross publicly announced that his firm would do the job free. "I got call after call, e-mail after e-mail saying that Bill offered was right for the country and that he was a great American," says a Pimco spokesman, Mark J. Porterfield. At first, it looked as if the Treasury might take Mr. Gross up on the offer. But his hopes were temporarily dashed when the Treasury simply gave TARP funds to the banks instead of purchasing bad assets.
And at the same time, people began to wonder about Mr. Gross's motives. He made it clear that he was not afraid to put Pimco's interests ahead of the government's in the bailout. As part of its "shake hands with the government" strategy, Pimco had bet that the Bush administration would come to the rescue of the nation's banks and other financial institutions. So it bought a variety of those bonds, including those of GMAC, the financial division of General Motors.
In November, as the economy continued to weaken, GMAC asked the Fed for permission to become a bank holding company so it could receive TARP financing. The central bank granted GMAC's wish, with one caveat: GMAC had to swap 75 percent of its debt for equity, allowing GMAC to potentially buy back a big chunk of its bonds for just 60 cents on the dollar.
Mr. Gross balked at the arrangement because, as a GMAC bondholder, he would have been forced to take a big financial haircut. "We said: 'It doesn't look too good on us. We think we'll just hold onto the existing bonds,' " he remembered. Much to the amazement of many people on Wall Street, the Federal Reserve, which declined to comment, still allowed GMAC to become a bank holding company and the government later guaranteed all of its debt, meaning that Mr. Gross's GMAC bonds would be worth 100 cents on the dollar when they mature.
Mr. Gross is unapologetic about the outcome. "The government has a vested interest, and it's not necessarily aligned with Pimco's interest," he says.
Simon Johnson, a former chief economist for the International Monetary Fund and now a professor at the Sloan School of Management at M.I.T., says he isn't surprised that Mr. Gross is such a virulent foe of nationalization. As Professor Johnson points out, Pimco is a major bondholder in some of the biggest banks. Nationalization would hurt his portfolio.
"It would reduce the present value of his holding," says Professor Johnson, himself a proponent of nationalization. "Therefore, he is not going to look good as an investment manager."
What of Mr. Gross's predictions that nationalization would deepen the recession? Professor Johnson acknowledges that there are risks either way, but says he thinks that people should be skeptical when powerful financiers make doomsday predictions.
"I think we pay undue deference to people who are very rich and have been successful in the financial sector in this country," he says. "We think they are the gurus who think they have unique expertise, and if Bill Gross tells us there will be a panic, it must be true. Well, no, I don't believe it. These guys all say this kind of thing."
The twist, of course, is that the Obama administration has embraced the same public-private partnership proposal that Pimco has been pushing along and that Mr. Paulson briefly considered last fall. Mr. Gross says that the Geithner plan was better because the government provides such generous debt financing.
Pimco is proud of its partnership with the government. Mr. Erian points out that the firm's executives have been members of the Treasury Department's Borrowing Advisory Committee (along with many other Wall Street executives) for years. Its current representative, the Pimco managing director Paul McCulley, says part of his job is to ingratiate himself with officials at the Treasury and the Federal Reserve so Pimco can better understand impending policy decisions. He boasts that he is on a "first-name basis" with both Mr. Geithner and the Fed chairman, Ben S. Bernanke.
"We have a whole lot bigger profile now than we did years ago, but the fact of the matter is we've been doing the same thing in the last year that we've been doing for the last 10 years," Mr. McCulley says. "I'd like to think we're having some influence in the public policy arena. And I say that first and foremost as a citizen."
Citizen - but also investor. And some critics of the financial benefits that Pimco might snare if the P.P.I.P. gets rolling are quick to point out what Pimco stands to gain.
"The critics would argue that all the benefits go to Pimco," says Representative Scott Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee and a skeptic of the Geithner plan. "Well, maybe not all the benefits. But they get the best ones right out the door. And the taxpayers are on the hook."
The Obama administration says it will soon select lead fund managers for P.P.I.P. It's almost certain that Pimco will be among them. "If you are trying to encourage investment from the private sector, isn't it only logical to involve the most successful asset management organization in the private sector?" says Thomas C. Priore, chief of ICP Capital, a boutique fixed-income investment bank.
And being selected by the government has other benefits, Mr. Priore adds. "If any endowment or public pension plan representative is looking for an asset management firm, he or she won't get fired for hiring Pimco because, well, the government hired Pimco," he says. "That certainly enhances your franchise value."
P.P.I.P.'s fate remains uncertain. When the Treasury Department put 19 of the nation's largest banks through a stress test, many passed the exam and their stocks prices rose. They have raised $50 billion in new capital. Now some of them are likely to hold on to their distressed mortgage securities in the hope that the housing market recovers - rather than face the pain of selling the assets at a loss now (a situation that may get dicey if housing doesn't, in fact, recover).
The Treasury now says that Mr. Geithner expects P.P.I.P. to serve as "backstop" for banks that find themselves in a pinch.
There's a darker scenario, possibly. If mortgage default rates do soar, some big banks may fail. Then the administration would have to seriously consider nationalization, which might devastate Mr. Gross's holdings. He is, of course, well aware of this possibility and says he's watching Mr. Geithner as closely as he watched the blackjack dealers in Las Vegas.
"We just don't want to flush it all down the drain," he says. "You want to shake hands with the government. But maybe it shouldn't be a super-firm handshake."
At a lunchtime meeting this past spring at Pimco, executives tell Mr. Gross that they're worried about the fallout the firm will face if it receives a financial windfall as part of P.P.I.P.
"The risk is that you have a Congress with a populist bug," Mr. McCulley says.
Dan Ivanscyn, another of the firm's managing directors, agrees. "I think there is a risk that we're going to get criticized," he says. "I think Pimco could get roughed up."
"I think there is a much bigger chance of us getting roughed up personally," says Scott Simon, head of Pimco's mortgage-backed securities team.
Finally, Mr. Gross weighs in.
"So what are you saying?" he asks. "If we fail, we'll get the shaft, and if we succeed, we'll get the shaft?"