"Bill Gross’s decision to back out of a $38 billion bond swap for GMAC LLC debt is paying off "

My question about Pimco and GMAC has been answered:

"Gross Wins ‘Game of Chicken’ Shunning GMAC Debt Swap (Update1)

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By Caroline Salas and Ari Levy

Jan. 9 (Bloomberg) -- Bill Gross’s decision to back out of a $38 billion bond swap for GMAC LLC debt is paying off for his Pacific Investment Management Co. investors now that the U.S. government has bailed out the auto and mortgage lender( THIS LOOKS BAD IF PIMCO IS PARTICIPATING IN BUYING MORTGAGES FOR THE FED ).

Pimco, manager of the world’s biggest bond fund, reneged on a Dec. 15 agreement to join an investor group participating in GMAC’s debt swap and ignored warnings that bankruptcy might follow. While holders led by Dodge & Cox accepted as little as 60 cents on the dollar to reduce GMAC’s debt, the bonds Pimco kept soared as much as 83 percent, to 80.5 cents on the dollar, after GMAC won approval to become a federally backed bank( COLLUSION ? ).

Gross, whose fund beat 99 percent of its peers in the past five years, won a bet that the U.S. wouldn’t allow Detroit-based GMAC to fail because its car loans were needed to prop up General Motors Corp. The government approved GMAC’s conversion to a bank on Dec. 24, giving it access to the Treasury’s $700 billion rescue program even though the debt swap didn’t get the 75 percent participation required by the Federal Reserve.

“It was a game of chicken,” said Sean Egan, president of bond ratings firm Egan-Jones Ratings Co. in Haverford, Pennsylvania. “Some investors benefited whereas others were harmed. They were harmed because they relied on information that was provided by the federal government, which proved to be inaccurate.”

GMAC’s $797 million of 7.25 percent notes maturing in 2011, which Pimco owned as of September according to data compiled by Bloomberg, rose to 80.5 cents from 44 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Holders who tendered those notes for cash got 70 cents on the dollar.

Ownership Stake

GM owned all of GMAC until the Detroit-based automaker sold a 51 percent stake for $7.4 billion in 2006 to a group led by Cerberus Capital Management LP( SNOW WORKS HERE ), the New York-based private equity firm. In 2007, GMAC financed about 75 percent of the inventory at GM dealers and a third of GM car buyers.

Soured subprime mortgages and plunging auto sales led to $7.9 billion of losses over the past five quarters, raising doubt about the lender’s survival. GMAC applied to become a bank on Nov. 20 so it could get access to federal rescue funds, and the bond swap was designed to help the firm qualify. GMAC said the Fed would reject its application if less than 75 percent of the debt covered by the swap was tendered.

While Pimco was part of the investor group that negotiated better terms and then agreed to tender $10.5 billion in debt, the firm never surrendered its holdings. Gross’s refusal to participate cast doubt on whether the debt swap would be completed, sending GMAC bonds down as much as 5.5 cents.

Relaxed Rules

Gross, 64, told the New York Times last month he wouldn’t tender because Cerberus was trying to bully creditors to reduce their claims by as much as half. Gross told the Times he wanted Cerberus to put more money into GMAC. Pimco owned more than $340 million of GMAC debt as of Sept. 30, according to regulatory filings and Bloomberg data.

Only 59 percent of the bonds were tendered. Instead of allowing GMAC to fail, the government relaxed its requirements for the debt exchange and provided $6 billion in aid, saying that the lender’s collapse must be prevented to protect GM, the biggest U.S. automaker, and the nation’s economy. Cerberus and GM must divest most of their ownership under the accord.

“The government said that they needed X, and when push came to shove they were willing to settle for a lower number than X,” Egan said. “Certain investors either through direct knowledge or through other means( COLLUSION ? ) were able to determine that the Fed was willing to bend its rules for bank holding companies.”

Bond Rally

Pimco, a unit of Munich-based Allianz SE, manages almost $800 billion in assets, including the $128 billion Total Return Fund. Led by Gross, the fund returned 4.8 percent last year, in the 93rd percentile among its peers, according to data compiled by Bloomberg. It returned an average of 5.4 percent over the past five years, in the 99th percentile.

Mark Porterfield, spokesman for Pimco in Newport Beach, California, declined to comment. Analyst Adam Rubinson of Dodge & Cox, who led the bondholder committee, declined comment.

“The bonds have rallied tremendously based on the fact they’ve received this federal support( TRUE ),” said Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago. “There’s improved odds they would be paid off at 100 percent. So, that would be better than people who had to make concessions” in the exchange offer, she said.

The cost of credit-default swaps protecting against a GMAC default has plunged since Dec. 24 to levels that indicate about an 18 percent chance of default over one year, compared with 45 percent before the swap, according to CMA DataVision in London.

‘Dumb Luck’

The upfront price of five-year credit-default swaps on GMAC have dropped 28.5 percentage points to 15.5 percentage points, CMA data show. That’s in addition to 5 percentage points a year and means it would cost $1.55 million initially and $500,000 a year to protect $10 million of GMAC bonds. Credit swaps pay the buyer face value in exchange for the underlying bonds, or the cash equivalent, if the company defaults.

Shanley recommends investors take advantage of the rally and sell because GMAC may continue to report losses and require more capital. Should GMAC fail, the guaranteed( YES ) notes issued in the exchange would rank ahead of the old notes for repayment.

“The company is in a much more competitive position for the long term as a result of the bank holding company approval,” said Gina Proia, a spokeswoman for GMAC. “We needed to execute the things we did in order to get the approval. Everyone is in a better position.”

Holders of notes that were ineligible for the exchange, such as individual investors who held about $14.6 billion of so- called SmartNotes, also gained from the deal. GMAC’s 7.5 percent SmartNotes due in 2017 climbed to 41.5 cents on the dollar from 15 cents before the conversion, Bloomberg data show.

They’re benefiting from “dumb luck,” said Egan of Egan- Jones. “GMAC is certainly out of the woods for the next 12 months. After that, it’s an open issue.”

I think that Pimco has to step away from buying MBSs for the Fed. I like Pimco and William Gross, but this could easily lead to accusations of collusion and conflict of interest. They made out in the GMAC bailout, and they should be happy with that.

“For the first time in our 10-year history we are buying distressed debt,"

I've talked about the news that John Paulson was purchasing Toxic Assets. Here's Tracy Alloway on Alphaville hearing of a similar case:

"Would you buy “the most toxic mortgages ever written”? Posted by Tracy Alloway on Dec 10 15:57.

Because T2 Partners, the New York hedge fund run by value investor Whitney Tilson, is. From Reuters:

NEW YORK (Reuters) - Hedge fund T2 Partners LLC on Monday for the first time was buying distressed U.S. mortgage securities on bets that losses on underlying loans will fall far short of expectations, founder Whitney Tilson said.

“For the first time in our 10-year history we are buying distressed debt, and we are selling equities to do it, Tilson said at the Reuters Investment Outlook Summit in New York.

The $100 million fund put between 10 percent and 25 percent of its capital in the mortgage securities, which include pools of subprime home loans that triggered the global financial crisis, he said.

For T2, traditionally a stock investor, mortgage debt has surfaced as one of the best investment areas in years since forced selling has pushed prices below levels that signal even catastrophic losses, he said. Many of the bonds that were once rated “AAA” are trading at 30 cents to 40 cents on the dollar, and offer “enormous” returns on capital, he said…

They are “pools of the most toxic mortgages ever written,” he said. “The characteristics of these would really make your jaw hit the floor.”

You can make your own judgement of the move, but we’d note that Tilson did have some prescient views on the housing bubble back in March…"

Of course, you have to wonder about the validity of these claims, but, if true, it seems that someone is able to price, value, assess, and buy these Toxic Assets. Why do we need the government to do it exactly?

Can William Gross Be Right About This?

I respect William Gross. In fact, he's one of the few financial people I listen to, but I have no way to know if he's right:

"And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that."

This seems a vastly rosy scenario, but who the hell knows?