Through the second half of 2011, debate raged in financial markets over whether the U.S. Federal Reserve would embark on a third round of massive bond purchases, known as “quantitative easing,” to shore up an anemic economy. Pacific Investment Management Co. wasn’t waiting to find out.
The giant fund-management firm, led by co-founder Bill Gross, started buying tens of billions of dollars in mortgage-backed securities guaranteed by federally sponsored agencies like Fannie Mae and Freddie Mac. In the third quarter of 2011 alone, Pimco’s flagship Total Return Fund, the world’s largest mutual fund, doubled its holdings of these securities to $80 billion, according to a Reuters review of trading and other data.
While Pimco was building its hoard, the Fed, in a surprise move long before any word on quantitative easing, said it would start buying more of the same kind of debt, known in the trade as “agency MBS.” The U.S. central bank would acquire as much as $30 billion of the securities a month by reinvesting proceeds from its earlier purchases. Prices rose.
As 2011 slid into 2012, Pimco started enjoying big gains on its agency holdings. Even better, the Fed in September 2012 finally announced a third round of quantitative easing, nicknamed QE3. To keep supporting the U.S. housing market, it would buy even more agency MBS. Pimco’s Total Return Fund posted billions more dollars in gains.
Pimco’s winning bet unfolded like this:
* In December 2008, the Fed hired Pimco, along with three other big Wall Street firms, to implement enormous purchases of agency MBS to keep interest rates low and spur the U.S. economy.
* Over the next few years, Pimco repeatedly invested heavily in those same securities – far more than other big investors, even considering its size.
* Pimco’s mortgage plays in 2009 and 2012 – when Fed buying was heavy – handed the firm and investors in the Total Return Fund a gain of $10 billion, excluding net investment flows, according to Reuters estimates.
There is no evidence of illegality or impropriety in Pimco’s actions. Pimco says that it kept its employees who were helping the Fed at arm’s length from those investing for its funds, and that its bond-buying bet was conceived before the Fed’s program was begun. The Fed says it implemented and enforced strict controls over the trading done by the firms.
But Pimco’s ability to enrich its returns by following the Fed does illustrate how the Fed’s easy-money policy over the past five years has produced outsized winners. As one of them, Pimco benefited enormously from the very Fed policies that it was helping to implement.
On the money
A Reuters review of more than 14,000 trades by the Federal Reserve Bank of New York and Pimco over the past five years shows that Pimco has consistently been on the money in anticipating the Fed’s actions in the agency MBS market.
Gross and other Pimco executives credit their success to the Fed’s transparency in announcing its intentions and to their own expertise in buying assets when they are cheap and in analyzing the broader economy. “Anticipate, then buy what they buy, only do it first,” as Gross put it in the January 2009 installment of his monthly “Investment Outlook” on Pimco’s website.
The Reuters analysis of quarterly Pimco Total Return Fund holdings and of Fed actions suggests that Pimco’s expertise was augmented by other factors: its size, the Fed’s choice of an intervention program perfectly tailored for Pimco to exploit, and a close relationship with the Fed.
The firm had brought in former Fed Chairman Alan Greenspan as a consultant in 2007. Gross’s top lieutenant, Mohamed El-Erian, serves on an advisory committee to the central bank’s most important branch, the New York Fed. Pimco’s global strategic adviser, economist Richard Clarida, has known Fed Chairman Ben Bernanke for three decades and was reported to be in the running for a seat on the Fed’s board of governors in 2011.
Pimco, a unit of German financial-services firm Allianz SE, was one of four firms the central bank hired to help it buy agency MBS in 2009 under the first phase of quantitative easing, called QE1. In essence, these firms collaborated with the Fed on writing its playbook for the program. The aim was to stimulate lending and spending by driving down interest rates through mass purchases of bonds, flooding the market with cash.
Two of the other three Fed helpers—Goldman Sachs and BlackRock—also scored big returns on bond funds during the program. However, they didn’t bet on agency MBS to the degree Pimco did. Reuters was unable to determine whether the fourth contractor, advisory firm Wellington Management Co, was advising any funds trading mortgage securities at the time.
Pimco, by contrast, exhibited a rare confidence in its agency MBS trading. At one point in March 2009, for example, 91 percent of the Total Return Fund’s assets were in agency MBS, according to data from investment research firm Morningstar Inc. That level was unusual for the fund and far exceeds that of any comparable fund at the time. By contrast, agency MBS accounted for 38.7 percent of assets in the Barclays U.S. Aggregate Bond Index, the industry benchmark.
In his January 2009 web posting, Gross said Pimco’s aim was to “shake hands with the government.” And in an interview with Reuters in February this year, he said: “It is a good strategy to anticipate what the Fed is going to do, and when they do it, to cooperate with them. … So that is what we’ve been doing.”
“Pimco knew the policy that the Fed was attempting to achieve, and it could readily stock up on those types of securities,” says Anthony Sanders, professor of real-estate finance at George Mason University. “Buying for the Fed in the volumes that the Fed was buying would almost certainly result in price increases in the specific MBS. So why wouldn’t Pimco build a quick portfolio of these securities and take advantage of valuation increases or cash returns?”
Doing so was perfectly permissible under the Fed program. The central bank allowed Pimco and the other three firms to continue trading in agency MBS while some of their employees were seconded to the central bank. Contracts that the firms signed with the New York Fed prohibited the firms’ traders or employees from discussing their work.
“Based on what has been shown to us by Reuters, the New York Fed has no reason to believe that Pimco behaved improperly as an investment manager,” a New York Fed spokesman said.
A spokesman for Pimco said its “investment performance is the result of the firm’s analysis of an extensive volume of publicly available information as well as its valuations of securities. These, and no other factors, contributed to the risk-adjusted returns delivered for the firm’s clients … with respect to agency mortgage backed securities.”
In earlier installments of its Uneasy Money series, Reuters showed how the Fed’s bond purchases, while underpinning the U.S. economy’s recovery, have created asset bubbles in unexpected places. Investors chasing higher returns have piled into subprime auto loans, for example. Much of the benefit of the cheap credit has flowed to well-to-do investors even as the job market remains soft. Some financiers have profited on the very same subprime mortgage bonds that nearly sank the financial system five years ago.
In the case of Pimco, the issue isn’t economic or market distortion. Rather, it is the appearance of a possible conflict of interest by allowing Pimco to act for the Fed and its own investors at the same time.
“The Fed provides non-public information on new programs to select private parties that trade the same securities as a fiduciary to investors and, after creating the program with the input of those firms, hands contracts to those same firms to purchase securities both for the Fed and private investors,” says Joshua Rosner, managing director of independent research firm Graham Fisher & Co.
Teaching and learning
At the height of the financial crisis in 2008, when the Fed’s initial announcement of quantitative easing was still several months away, Pimco was overweight in agency MBS. The Total Return Fund was increasing its holdings of the securities when, on September 7, the U.S. government seized control of Fannie Mae and Freddie Mac amid the agencies’ mounting losses.
The next day, the bond fund posted a 1.32 percent return, one of its strongest days ever, as prices of mortgage securities rose. By the end of the month, 74.8 percent of the fund’s holdings were in agency MBS, compared with 59.13 percent in December 2007.
A Pimco spokesman said the firm “began overweighting mortgage exposure when our analysis indicated that these mortgages were attractive relative to other investment opportunities, which was well before any managers were hired by the Federal Reserve, before the AMBS purchase program was announced by the Federal Reserve, and presumably before the program was even conceived.”
Then, on November 25, as the collapse of Lehman Brothers and the U.S. government bailout of American International Group reverberated through the global financial system, the Fed announced a support plan for the economy. Among other measures, it would buy up to $500 billion in agency MBS.
Rosner of Graham Fisher says the Fed could have avoided any appearance of conflict of interest if it had hired its own traders. But the central bank had never bought agency MBS on such a scale, and it decided it needed help. It turned to the pros: Pimco, Goldman, BlackRock and Wellington, all of which were selected through competitive bidding. Together, they set up operations to buy agency MBS for the Fed, starting in January 2009.
“The firms were chosen because their deep experience with agency MBS markets would enable the New York Fed to launch the program quickly while minimizing risk,” a New York Fed spokesman said.
Among other controls, the spokesman said, the New York Fed required the firms to physically separate trading staff from other employees. They also had to ensure that no information flowed between the traders making purchases at the New York Fed’s direction and other traders at the firms. Each firm had to certify in writing that it was in compliance with the required controls and was subject to internal and external audits.
Pimco assigned star trader Dan Hyman to help oversee the firm’s role in the project. The operation was set up in a secure room at Pimco’s Newport Beach, Calif., headquarters. Access required a keycard.
The Pimco team, according to a person familiar with the program, held daily calls with counterparts at the other firms and with the New York Fed. On the calls, the group discussed which securities to buy for the Fed and when.
Goldman said it “created a separate, dedicated team to manage the Federal Reserve program that was walled off with both physical and informational barriers and technological firewalls.”
BlackRock said that its buying for the Fed was carried out by BlackRock Solutions, a separate business from its money-management arm, and that “strict and effective policies and procedures” were in place to manage potential conflicts of interest.
Wellington declined to comment for this article.
Pimco’s size was well-suited to the Fed’s program, relative to its peers. The Total Return Fund, with $251.1 billion under management, dwarfs other actively managed bond funds. The next largest managed intermediate bond fund, the DoubleLine Total Return Fund, has just $35.4 billion under management.
That means that to generate meaningful profits from the tiny increments in which mortgage bond prices move, Pimco had to make big bets. To do that, it used a huge but little-known agency MBS derivatives market, called the to-be-announced, or TBA, market, taking positions many times larger than those of its fellow Fed contractors.
And the only way the Fed could buy agency MBS in bulk was through the TBA market. Here, investors enter into contracts to buy at a later date pools of agency MBS with certain generic characteristics in commonsuch as the maturity and the coupon, or initial interest rate. At settlement, the seller delivers a bundle of various newly issued and existing bonds that meet the criteria.
The broad specifications in the contracts give the TBA market much more liquidity and depth than any other market for mortgage bonds, making it easier for participants to trade huge amounts of securities. Thus any investor familiar with agency MBS could have guessed that the Fed would use the TBA market. Also, the Fed publishes its trading results weekly.
“Here is the Fed saying, ‘We’re going to make this huge, huge investment in mortgage-backed securities,” says John Merrick, a College of William & Mary finance professor who wrote about the TBA market in a 2012 analysis.
On March 18, 2009, the Fed increased its original $500 billion target for QE1 to as much as $1.25 trillion. (The Fed also said it would buy up to $300 billion in long-term Treasury securities.) That was a big day for Pimco: The Total Return Fund reported an unusually high 1.32 percent return, matching its gain when Fannie Mae and Freddie Mac were seized.
The fund was steadily increasing its TBA holdings by more than twentyfold, quarterly records show, from about $2 billion in June 2008 to $43 billion at the end of March 2009. That’s when the Total Return Fund’s overall agency mortgage exposure reached an extraordinary 91 percent of total assets, or $132 billion.
Over the course of the year, former Fed Chairman and then-Pimco consultant Greenspan met twice for breakfast with current Fed Chairman Ben Bernanke—on March 5 and on July 9, according to Bernanke’s calendar. What they discussed isn’t known.
Greenspan, who has since left Pimco, declined to comment. A spokesperson for the Fed declined to comment, citing guidelines that prohibit the release of confidential information.
Pimco invested in agency MBS that then rose in value when Pimco’s Fed advisory team bought the same securities for the Fed.
By the end of March 2009, for example, the Total Return Fund owned $1.26 billion of a Fannie Mae 30-year TBA security paying 5.5 percent, valuing it at 103.55 cents on the dollar, according to quarterly data on the fund’s holdings. Then, between April 17 and May 6, Pimco bought $11 billion of the same security for the Fed’s books, paying a higher price of 103.81 on average, the Fed’s trading records show.
Overall, the Reuters analysis shows that of the $186 billion of Fannie Mae TBA securities Pimco bought on behalf of the Fed during QE1, it owned at least $80 billion of the same securities.
For all of 2009, Pimco’s Total Return Fund posted a return of 13.83 percent. It was the fund’s best showing in a decade, beating the Barclays U.S. Aggregate Bond Index by nearly eight percentage points—its widest spread over the benchmark, according to Morningstar, since 1988, the fund’s first full year of operation. By far the biggest contributor—at 4.15 percentage points—was the fund’s bet on mortgage bonds of all types, according to a confidential breakdown of the fund’s returns obtained by Reuters.
It’s not known how much agency MBS specifically contributed to that return, but two reports from the time highlight how Pimco cashed in on the agency MBS market. In a September 2009 report to investors, Pimco said the firm’s oversized bets on agency MBS were “strongly positive for returns” and that values had “richened substantially.” In November 2009, Morningstar analyst Eric Jacobson wrote that “a sizable government mortgage bet has been the fund’s most helpful in 2009. Large mortgage purchases by the Fed have drained supply and pushed up prices.”
Goldman and BlackRock also ramped up their holdings of agency MBS. They didn’t do so as aggressively, but their funds, which are smaller, managed to score even better returns than Pimco’s flagship fund.
One of Goldman’s largest bond funds and its closest peer to the Pimco Total Return Fund is the $1.2 billion Core Fixed Income Fund. It cut its agency MBS exposure to 31 percent in March 2009 from 47 percent in December 2008, suggesting that the fund took some profits on Fed buying. The level then remained fairly static over the ensuing months. The fund posted a 16.3 percent return for 2009.
From the end of 2008 to March 31, 2009, the $2.9 billion BlackRock Total Return Fund’s holdings of agency MBS fell to 43.5 percent of assets from 46.5 percent, while the $2.8 billion BlackRock Core Bond Fund’s agency MBS holdings fell to 40.4 percent from 46.4 percent. These shifts suggest both funds were able to book some gains by selling into Fed buying, but without having made any bets far in excess of the Barclays benchmark. BlackRock’s Total Return Fund and Core Bond Fund returned 15.2 percent and 14.5 percent, respectively, in 2009.
For their services to the Fed in 2009, Pimco, Goldman and BlackRock were paid $11.2 million apiece, according to a 2011 U.S. Government Accountability Office report. Wellington was paid $26.6 million under an extended contract to March 2010. From then on, the New York Fed, having gained expertise in buying agency MBS, managed its own trading desk.
The Pimco spokesman said the firm “strictly adhered to all of the Federal Reserve’s program policies and procedures that were established to prevent conflicts of interest and maintain confidentiality of all non-public information. Pimco’s participation in the program did not confer to the firm any informational advantage, both during and at any time after Pimco’s work on the program.”
It isn’t known when Hyman returned to his job on the firm’s mortgage bond trading desk. Based on the contract that Pimco signed with the New York Fed, a Pimco employee would have had to adhere to a “cooling off” period of about six weeks. Those who worked for the New York Fed were forbidden by contract to use any knowledge gained from working for the Fed when trading for Pimco.
Hyman didn’t respond to requests for comment.
In November 2010, the Fed announced a second round of bond buying, known as QE2. This time, the central bank said it would buy $600 billion in longer-term Treasury securities.
Pimco didn’t do as well in its bets on the much-bigger Treasury bond market as it did on agency MBS.
In early 2011, as the Fed approached the end of its QE2 purchases, the Total Return Fund sold its Treasury holdings, according to Pimco data. But it misread the market. Treasuries rallied as a sovereign debt crisis raged in Europe and investors sought the safety of U.S. government bonds. On June 30, the Fed completed QE2.
Immediately, market chatter turned to whether there would be a QE3, amid a persistently sluggish U.S. economic recovery.
El-Erian, an Oxford and Cambridge graduate who has held top positions at the International Monetary Fund and Harvard University, said Gross’s view at the time was that economic conditions would require the Fed to return, because “we are nowhere near escape velocity.”
Pimco started buying agency mortgage bonds again. On September 21, 2011, as the Total Return Fund’s holdings of TBA securities approached $50 billion, the Fed, in a surprise move, said it would begin reinvesting principal payments from agency MBS and other debt it owned. That meant the Fed, to Pimco’s benefit, would begin buying up to $30 billion of mortgage securities a month.
‘Lots of Smiles’
By March 2012, the Total Return Fund’s agency mortgage investments were back up to about half of the fund’s total holdings.
Indeed, between June 2011 and June 2012, Pimco again exhibited unusual confidence in its agency MBS bets. Among the top 20 actively managed intermediate bond funds, the three that made the largest increases in their agency MBS investments during that period were managed by Pimco, Morningstar data shows. The Harbor Bond Fund, managed by Gross, raised its exposure by more than 40 percentage points, the Pimco Total Return Fund by about 30 points, and the Pimco Investment Grade Corporate Bond Fund by 24 points. None of the other top 20 funds had a double-digit increase.
The Total Return Fund zeroed in on agency MBS that had relatively low coupons. “We liked them” because they were “cheap,” says Scott Simon, then head of Pimco’s mortgage trading desk, who has since retired. Additionally, “if the Fed wanted to shore up the housing market and create refinancing, they would lower the mortgage rate. If they wanted to lower the mortgage rate, they would buy (bonds with coupons of) 3 percent and 3.5 percent.”
That prediction was validated as the Fed bought Fannie Mae securities that paid a 3.5 percent coupon in 2012, before announcing QE3.
“That is a dynamite combination when you have a cheap asset with the possibility of the central bank buying … billions of them down the road,” Gross said. “It’s not a ‘can’t miss’ proposition, but it’s a decent ‘odds on’ proposition.”
The party continued after Bernanke finally announced QE3 in September last year. Gross said there were “lots of smiles but no high fives” at Pimco’s investment committee meeting that day. “As I remember it personally, it was a silent but emphatic ‘Yes!’—with an exclamation point.”
The Total Return Fund’s mortgage holdings once again jumped in value. All told, the Fed added nearly $500 billion of agency MBS to its books in 2012, switching from securities with mainly 3.5 percent coupons before the QE3 announcement to 3 percent after. Pimco followed suit.
By the end of the year, the Total Return Fund was up 10.36 percent, exceeding the Barclays benchmark index by six percentage points. That 10.36 percent gain equates to about $25.3 billion, excluding net investment flows. About $5 billion came from bets on agency and non-agency mortgage securities, according to Reuters estimates. The fund’s banner year was also helped by smart calls on Treasury bonds and corporate debt.
Pimco is struggling this year because it again failed to correctly call the bond market, which sold off sharply in May and June. “Selling begat more selling, even in Treasuries,” Gross wrote in one of his recent web postings.
On May 22 and again on June 19, Bernanke hinted that the central bank might cut back on QE3, leading to sharp swings in Treasury values as investors sought to sell ahead of the Fed. Yields on the 10-year Treasury, which hit 1.61 percent on May 1, soared to 2.52 percent at the end of June. Investors withdrew $9.6 billion from the Total Return Fund in June, a monthly record, according to Morningstar. The fund is down about two percent so far this year, according to Pimco’s website.
Still, Pimco has locked in much of its gains on agency MBS by selling down its hoard to the Wall Street dealers who then sell to the Fed. “You never go broke taking a profit,” Gross said. “We’ve sold … tens of billions of agency mortgages to the Fed, which is … basically what we intended to do.”