The Power of Pimco

Bill Gross, who runs a bond fund bigger than the GDP of most countries, finds that using his firm's trading clout can roil markets and draw legal fire.

By Seth Lubove and Elizabeth Stanton
Bloomberg Markets April 2008

To classify Pacific Investment Management Co. as a large mutual fund family does it little justice. Its $747 billion in bond assets almost matches the gross domestic product of Australia. The flagship Total Return Fund's $113 billion surpasses the economies of Egypt, New Zealand, Ukraine and 130 other countries ranked by the World Bank.

Bill Gross, Pimco's chief investment officer, has his own analogy. He likens Total Return to Shaquille O'Neal, the 7-foot-1-inch (2.2-meter), 325-pound (147-kilogram) center of pro basketball's Phoenix Suns.

"No doubt, we could be more nimble if we were a billion rather than $113 billion," says Gross, who turns 64 in April and has run the fund since its birth two decades ago. "It's like saying Shaq should play point guard." For the long haul, he'll stick with heft: "We should really be a 7-foot center, where the game is dominated."

Not unlike O'Neal, who leads the National Basketball Association in fouls per game, Pimco's sheer bulk is making the Newport Beach, California-based firm vulnerable to accusations it throws its weight around. While Pimco can use its size to win the inside track in deals or lower transaction costs, fund specialists and researchers say a behemoth like Pimco can also hamstring its own trading flexibility and sap liquidity from an entire market.

"It's a double-edged sword, having huge size in the markets," says Don Phillips, a managing director at Chicago-based research firm Morningstar Inc. "The negatives would tend to outweigh the positives--unless you're very smart about using the positives to your advantage and to your clients' advantage."

One allegation of a flagrant foul is playing out in a Chicago federal district courtroom, where the lawyer who won a $1 billion antitrust settlement against Wall Street market makers in 1998 is claiming that Pimco intentionally manipulated the Treasury futures market in mid-2005 in violation of the Commodity Exchange Act of 1936.

In the year and a half following the alleged manipulation, regulators acted, through rule changes and public scoldings, to shore up the integrity of the U.S. Treasury market, which has about $4.5 trillion in outstanding securities. Investors view Treasuries as among the world's safest and most liquid investments. Any taint of artificial prices can interfere with the U.S. government's ability to finance its budget deficit at fair and reasonable prices. "In any market that is manipulated, your players will drop out, whether it's the international community, investors or speculators," says Thomas di Galoma, head of U.S. government bond trading at Jefferies & Co., the New York investment bank.

According to the 2005 complaint, filed by New York lawyer Christopher Lovell, Pimco bought futures contracts and hoarded a majority of the most desirable notes underlying those contracts, purposely driving up the value of securities traders might need to fulfill their futures agreements. Lovell's firm, Lovell Stewart Halebian LLP, represents a hedge fund and two individuals who sold the contracts short and claim they had to pay higher prices to replace them.

While not naming Gross as a defendant, the suit says he participated in the so-called squeeze through purchases by Total Return Fund.

Pimco and Gross deny any manipulation. "The plaintiffs are a purported class of investors who took speculative 'short' positions and tried to profit from what turned out to be a bad bet," Pimco spokesman Daniel Tarman says. Federal regulators and the Chicago Board of Trade found no manipulation by Pimco, he says. In filings, Pimco vows a vigorous defense and frequently notes that no regulator sanctioned the firm.

"When you're this size, and this big, you're a target of class- action legal maneuvering," Gross says. "Like an elephant, you have to watch where you step, knowing there are people out there who are willing to make accusations."

The bond fund giant has so far failed to halt Lovell's suit, whose primary plaintiff is now part of Chicago options-trading firm Peak6 Investments LP. On July 31, 2007, U.S. District Judge Ronald Guzmán approved the litigation as a class action. "Here, considering the totality of the circumstances, it can be reasonably inferred from the facts alleged that Pimco Funds intended to cause artificial prices or otherwise manipulate the futures market," the judge wrote. Pimco appealed to the Seventh Circuit. On Feb. 6, 2008, Pimco requested a 60-day stay to try to settle out of court. Lovell agreed to talk. ''The case is not anywhere close to over,'' says Christopher McGrath, a Lovell associate.

Lovell, 56, a failed 1980 Republican congressional candidate in New York, is seeking damages that Pimco estimates would exceed $600 million.

"I would have thought they wouldn't want to jeopardize their reputation by manipulation," Lovell says. "When some people enter your mind, you say, 'Yeah, they're capable of doing this.' And others you say, 'Why would they want to do that?'"

According to Guzmán's written decision, Pimco held as much as $13.3 billion, or 75 percent, of the Treasury notes traders needed to satisfy their futures contracts at the lowest cost. The case may hinge on when Pimco acquired those notes (the details are under court seal).

In general, whatever their intent, big fixed-income funds that hold unusually large positions in bond issues may find that their own size becomes a liability, says Michael Rosen, co-founder and chief investment officer of Santa Monica, California-based Angeles Investment Advisors LLC, a pension consultant to institutional investors. When it's time to sell, the pool of potential buyers is limited. "It makes it hard if you want to find an active buyer and get out," Rosen says.

The biggest market participants also attract an unwelcome spotlight, Morningstar's Phillips says. "Everybody is watching your every move," he says. "Just whispers that Bill Gross is doing something in the market can cause people to dramatically alter their own investment strategies. In an industry where good ideas are at a premium, your ability to execute can be limited if you're the most visible player in the marketplace."

Then again, Phillips says, if Pimco weren't large and prestigious, it might not have been able last May to attract former Federal Reserve Chairman Alan Greenspan as a paid consultant. Phillips also says Pimco's size, and deep pockets, helped lure back Mohamed El-Erian, an emerging-market debt specialist who left Pimco to run Harvard University's $35 billion endowment. El-Erian, 49, returned in January to become Pimco's co-chief executive officer, along with William Thompson, and co-chief investment officer, a job shared with Gross.

Small or large, bond funds and money managers are trying to wring profit from shrinking fee levels, Rosen says. "Fees have gotten very, very low," he says.

Annual fees and expenses for U.S. bond funds fell 14.4 percent to 83 basis points, or 83 cents per $100 invested, in 2006 from '01, according to the Washington-based trade group Investment Company Institute. The decline, which the group traces partly to increased competition, is more dramatic since 1980, when bond funds charged $2.05 per $100. Fees on stock funds fell slightly less: 13.7 percent, to $1.07 per $100, in '06 from '01.

Why do Pimco and the others bother with funds management? "It's like the joke about the Jewish deli," Rosen deadpans. "The food's no good, but the portions are huge. You have to ask them why they want it. I don't think they're making a lot of money on it."

Munich-based insurer Allianz SE, which bought 70 percent of Pimco in 2000 for $3.3 billion, won't say how much money Pimco is making; it doesn't break out results for the unit or its 37 funds. While Gross frets that size limits flexibility, he says it allows him to get first pick of deals. "Not only do we get the first phone call from Wall Street, we can call them because we can take on a billion or two billion at a crack," he says. "We can call up Barclays or Citi or Merrill or Bank of America directly."

"Size works both ways," he adds. "The record is the proof."

Gross is no slouch when it comes to performance. Pimco says his fund gained an average of 8.35 percent a year since inception through Feb. 1, beating the benchmark Lehman Brothers Aggregate Index's 7.51 percent. (Both figures include reinvested dividends.) He hit an uncharacteristic rough patch last year. In the first six months of 2007, Total Return gained just 0.35 percent compared with 0.98 for the Lehman index, according to data compiled by Bloomberg. Things got so bad in the first half that Gross put off his beloved August cruise vacation.

"It was a time not to lose money and start making it," he says. Total Return came storming back in the second half, earning 9.1 percent for the year compared with the index's 7 percent. Only in December did Gross break away, taking his wife on a cruise through the Panama Canal. On Jan. 3, Morningstar named Gross its "Fixed- Income Fund Manager of the Year," his third such honor since 1998. When the news flashed, Gross grabbed a portable microphone and jumped onto his desk. "I told everybody how proud I was of their effort, this year even more so than the other two," says Gross, who recently shaved off his trademark mustache in deference to his age. (He says he was using hair color to cover the gray until his wife said the dye was poison.)

Gross praises the firm's money market traders, among others, for staying away from asset-backed commercial paper and mortgage traders for avoiding securities containing subprime loans. The only challenge was getting off his desk. "I had to gingerly lower myself. Thank goodness for yoga," says Gross, who picked up the practice 10 years ago.

Gross's performance beat goes on. Total Return gained 3.46 percent this year through Feb. 8 compared with the Lehman index's 1.56 percent.

Thompson, 62, who joined Pimco in 1993 after a stint as chairman of Salomon Brothers Asia Ltd., says performance is what really counts, not asset growth. "You have to manage intelligently and efficiently," he says.

It was during yoga about two years ago that Gross had what he calls the "radical idea" of sending analysts into the field in Boston, Detroit, Miami and elsewhere to sniff out his hunch that housing was heading for a fall. He told them to act as if they were buying a house and hang out with real estate agents. He credits the research with helping him avoid getting swept up in the subprime debacle.

"It's better than government statistics on housing starts," he says. "I've made a lot of stupid mistakes, but this was one damn good idea."

According to Lovell, Gross was in the middle of the market anomalies in June 2005 that sparked the legal complaint. The case is complicated, reflecting complexities in the Treasury futures market. Futures are agreements to receive or deliver a specific amount of a commodity at a future date and a set price. In market parlance, buyers contracting to take delivery have a "long" position and sellers contracting to deliver have a "short" position. (The shorts aren't borrowing the security like so-called short sellers in equities.)

Delivery must occur when a contract goes to expiration. For Treasury futures, that's the last day of each quarter. In practice, deliveries are rare.

A trader can exit, or "offset," a short position by entering into an opposite long position. Lovell's plaintiffs claim they lost money when they exited their short positions by buying the June futures contract. They say Pimco drove up the price of that contract to artificial levels. The class of plaintiffs approved by Guzmán includes all who exited short positions and bought the June contract.

Pimco is active in Treasury futures, which are traded on the Chicago Board of Trade, or CBOT. Futures offer a way to invest in the underlying Treasury market without large initial outlays. The contract price rises and falls with the price of the underlying 10-year Treasury note. Instead of spending $1 million on Treasuries, an investor could go long 10 futures contracts, each specifying delivery of $100,000 face amount of securities. Investors and traders could post an initial margin of no more than $1,200-$1,620 per contract, leaving plenty of cash to invest elsewhere until it's time to either pay for the underlying notes or exit the position.

In April 2003, Gross boasted of futures' advantages. He wrote in a Pimco essay that he could use certain combinations of Treasury futures and other derivatives--contracts that derive their value from underlying securities--to augment his bond fund's performance by two-tenths of a percentage point a year. This can be accomplished "without even breathing hard," he wrote.

What happened in 2005? The answer lies in the way contracts are fulfilled at expiration. Usually, at least a dozen underlying Treasury notes--those with maturities ranging from 612 to 10 years--can be delivered to satisfy the contract. Market conditions make one note the most desirable because it's the cheapest to deliver. The futures contract tracks the price of that note.

For the June contract, the cheapest of 13 eligible notes was one with a 4 78 percent coupon maturing on Feb. 15, 2012. Normally, the number of contracts that stay open declines sharply in the last weeks of the contract's life as traders exit their positions in the expiring contract and take positions in the next contract. But on June 21, the contracts' last trading day, there were still almost 152,000 contracts open, and holders of more than 142,000 took delivery, according to the CBOT. That was almost double the previous record of 75,000 in December 2000.

Ultimately, all deliveries for the June contract--totaling $14.2 billion of notes--used the February 2012 security. But during the last weeks of trading, the contract's price had surged on speculation traders with short positions wouldn't be able to amass enough of those notes and would be forced to deliver more expensive ones as well. Compounding the shorts' pain, the February 2012 notes had become cheapest to deliver by what some traders say was the widest margin in memory. At the time, one trader said that those without the cheapest note stood to spend at least $1,000 more to settle each contract.

The so-called repo market, where repurchase agreements are entered into, shows the value of the cheapest note. Investors who want notes can borrow them by lending money in exchange for temporary ownership. Before the June contract expired, the February 2012 note traded at zero percent in the repo market, one trader said at the time. That meant investors were willing to lend money at zero interest to borrow the note.

Lovell alleges that Pimco, by the end of March, had an ''extraordinarily large'' long position of 163,169 June contracts, calling for delivery of $16.3 billion of notes. Then, contrary to its normal practice, Pimco held the contracts instead of "rolling'' them into September, the complaint says. It says Pimco also ''engaged in the highly unusual conduct'' of purchasing $13.3 billion worth of the cheapest-to-deliver Treasury note.

In court, Pimco has fought to keep details out of the public eye, getting Guzmán to seal many of the exhibits involving Pimco's trading strategies and customer names. Neither the firm nor Gross would comment on any of the case's details or expand on public remarks made in 2005.

Lovell, in targeting Gross, cites the purchase of a combined 119,129 June 2005 futures contracts by Total Return Fund and Total Return Fund II, a $2.3 billion fund Gross manages. That contract amount was "far larger" than Pimco's norm, Lovell says. Gross's deposition is sealed. "The fact is, at 63, I didn't do them much good because there's not that much I could remember," he says.

In August 2005, Gross told Bloomberg News that Pimco had acquired the February 2012 notes only when it took delivery on the June futures contracts and that its normal procedure was to roll its contracts. In an interview a month later, he said Pimco hadn't rolled the June contract because the September contract was "overvalued."

Traders involved at the time back that assessment. They say that as early as March 2005 it was apparent that the cheapest-to- deliver note for the September contract was likely to become scarce because of the relatively small amount of notes issued by the government. This had the effect of driving up the price of the September contract relative to June's--the so-called calendar spread. Gross would have been among those penalized.

A former high-ranking Pimco executive, Charles "Chuck" Daniels III, says the allegations in the manipulation case fit what he recalls. Without citing any specific documents or individuals, Daniels says Pimco created squeezes to try to compel delivery to the firm of underlying Treasury notes that were more valuable than the cheapest-to-deliver note. "That has been a fundamental, stated strategy for many, many years," says Daniels, 51, who was a Pimco executive vice president until 1999 and says he sat on the firm's executive committee. "You make that squeeze by figuring out what securities are deliverable for which contract, pick off the cheap ones and force everyone else to deliver stuff that's of much greater value to you. That's a fundamental program. They put a lot of energy into making that work."

Daniels, who lives in Irvine, California, left Pimco for medical reasons. He says the company has blackballed him from other investment management jobs so that he won't compete with Pimco, though he doesn't plan any legal action. Pimco has no comment except to confirm that Daniels worked at the firm, spokesman Mark Porterfield says.

Pimco has found itself up against a formidable opponent in Lovell. What Gross is to the world of bonds, Lovell is to commodities- manipulation and price-fixing lawsuits. A 1976 graduate of New York University's School of Law, Lovell decided after a few years in a now-defunct corporate law firm to set up shop on his own in 1980. "I thought I could add more value and get more money for myself working for plaintiffs," he says.

The native of Montana quickly made a name for himself by winning a $1.38 million federal jury verdict in 1983 for a client who accused Idaho potato billionaire J.R. Simplot and others of conspiring to manipulate the price of potato futures. In 1998, he earned a $1 billion price-fixing settlement in a suit against more than two dozen Nasdaq market makers. He also landed a $145.4 million settlement in 1999 against Sumitomo Corp. in a lawsuit that accused the Japanese trading company of manipulating copper prices.

In 2000, Lovell hooked up with Herbert Black, 64, a Canadian scrap metal dealer. Lovell drafted Black's price-fixing class action that year against Christie's International and Sotheby's, the first of several lawsuits that resulted in $552 million worth of settlements by the art auction houses. A federal investigation resulted in a one-year prison sentence and a $7.5 million fine for former Sotheby's Chairman Alfred Taubman.

Lovell decided to pursue Pimco shortly after an article in the New York Times in August 2005 suggested that Pimco's holdings of the February 2012 note made it a beneficiary of the June squeeze. Craig Pirrong, a professor at the University of Houston's Bauer College of Business, told Lovell the case might be worthy of the lawyer's attention, Pirrong said in a deposition last year. A frequent expert witness who specializes in commodities- manipulation cases, Pirrong declined to comment on the Pimco case because he's being paid as one of Lovell's experts.

In general, Pirrong says, squeezes occur frequently on commodities exchanges. "I once asked a grain trader if he ever squeezed the market, and he said no but he might give it a hug once in a while," Pirrong says. "So these things run the continuum from mild to severe, and the more severe they are, the more likely people are to squawk."

A memorable example occurred three decades ago in the silver market, resulting in a 1988 civil jury verdict against the Hunt brothers of Dallas: Nelson Bunker, William Herbert and Lamar. They were ordered to pay more than $132 million in damages to a commodities company owned by the government of Peru. The company, Minpeco SA, said it lost money because it had short positions in silver futures contracts whose prices shot up. The Hunts said their large futures purchases in 1979 and '80 hadn't improperly influenced the market.

In the Pimco case, company lawyers used their questioning of Pirrong to try to blame Citadel Investment Group LLC, the Chicago hedge fund firm run by billionaire Kenneth Griffin, for contributing to a squeeze because Citadel controlled $8 billion of the cheapest-to-deliver Treasury notes. Pirrong, in the deposition, called Citadel's role "completely irrelevant." Recent Pimco filings refer to Citadel as "Other Market Participant."

Citadel spokeswoman Katie Spring declined to comment.

While regulators haven't brought a complaint against Pimco, there's evidence government agencies were concerned. A Nov. 30, 2005, memo from the U.S. Commodity Futures Trading Commission staff to the five-member panel cites the June 2005 contract as one of four securities raising alarms among regulators. "In each instance, one or two traders had accumulated large long positions in the expiring futures contract and held those positions longer than is typically observed by surveillance staff," the memo says.

In addition, the CBOT acted within days of the squeeze. On June 28, 2005, it issued notice of a new rule that would place a ceiling on holdings in the last 10 trading days of a quarter: the maximum would be 50,000 10-year Treasury contracts. That was one- third of the amount Pimco held in the June contract. In its notification letter to the CFTC, the CBOT didn't explain its reasons or cite Pimco. (The restriction was later increased to 60,000.) CFTC spokesman Dennis Holden declined to comment. Preventing commodities misconduct is still a high priority at the CFTC, which regulates commodity futures and option markets, according to Acting Chairman Walter Lukken. In December testimony prepared for Congress, Lukken said that at any given time, the agency's enforcement arm is investigating or taking to court some 700-1,000 individuals and corporations for alleged fraud, manipulation and other illegal conduct.

In August 2005, then CEO Bernard Dan and Chairman Charles Carey of the CBOT defended the ceiling on holdings in a letter to the Futures Industry Association trade group, which had opposed the rule. "We established position limits precisely for the purpose of reducing the potential threat of market manipulation, congestion or price distortions," they wrote.

While Pimco's lawyers try to keep Lovell at bay, the firm is pursuing growth. Co-CEO Thompson says he's intent on attracting new clients. Pimco already has expanded to places such as China, where it was picked to help manage national pensions, and Japan, where it set up offices to distribute and manage bond funds. One overseas target is sovereign wealth funds, the roughly $3 trillion in foreign-currency reserves that the International Monetary Fund estimates is sloshing around in the treasuries of oil sheikdoms, China and other big exporters. Thompson has assigned the task to Richard Clarida, a Pimco executive vice president who was a former chief economist at the U.S. Treasury Department and onetime chairman of Columbia University's Department of Economics. Clarida, 50, spends much of his time shuttling between his New York base and Latin America, the Middle East, Asia and Europe. "Literally around the world, as my frequent flyer miles will attest," he says.

Closer to home, Thompson is trying to make inroads into the personal retirement fund market. Pimco gets more than two-thirds of its assets, or close to $500 billion, from pension funds. Clients include Boeing Co. and International Business Machines Corp. These private so-called defined-benefit plans are growing at less than half the rate of personal accounts called 401(k)s and similar investments, together termed defined-contribution plans. Under section 401(k) of the U.S. tax code, employees can invest in tax-sheltered accounts, making withdrawals when they stop working. Assets in the category that includes 401(k)s increased 31 percent to $3.27 trillion in 2006 from '00, according to the Federal Reserve's Flow of Funds report issued in December. The pension category grew by 14 percent to $2.26 trillion.

Leading the 401(k) charge is Stacy Schaus, a senior vice president hired two years ago after a 17-year career at Lincolnshire, Illinois-based human resources consulting firm Hewitt Associates Inc. The business constitutes 10 percent of Pimco's assets and is growing, Schaus, 47, says.

Gross says more growth in Total Return is inevitable and that he won't close his fund to new investors. By way of explanation, he quotes from the Bob Dylan song "It's Alright Ma (I'm Only Bleeding)." Dylan put it this way: ''He not busy being born is busy dying.'' Gross paraphrases: "If you're not growing, you're dying."

Regulators, meantime, have pushed Treasury market participants to avoid controlling unusually large amounts of securities that are in high demand. In September 2006, James Clouse, then the deputy assistant Treasury secretary for federal finance, told the Bond Market Association in a speech, "If the integrity of the secondary market were to be compromised by manipulative trading behavior, many investors could well migrate away from Treasuries in favor of other instruments."

Clouse cited a potential futures squeeze and added, "Left unchecked, that process could impair many of the special attributes of the Treasury market and raise the Treasury's cost of borrowing over time."

Clouse, now a senior associate director of the Federal Reserve Board, declined to comment on what prompted his remarks. Di Galoma, of Jefferies & Co., says the public scolding has helped clean up the market. "It's a much fairer game all the way around," he says. "I haven't heard the word squeeze in a while." With Bill Thompson pursuing a globe-trotting expansion strategy and Bill Gross attracting more and more money to his Total Return Fund, Pimco probably hasn't heard the word squeeze for the last time.

Seth Lubove is chief of the Los Angeles bureau of Bloomberg News. slubove@bloomberg.net

Elizabeth Stanton covers U.S. markets in New York. estanton@bloomberg.net

#<257571.18602.1.0.69.26862.25># -0- Mar/03/2008 20:19 GMT

		Email this article Printer friendly format