After the conversion, GMAC bonds rose in value; Pimco says it plans to hold them to maturity.

TO BE NOTED: From Fortune:

"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?

By Katie Benner, writer

Last Updated: March 30, 2009: 4:53 PM ET

(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."

'Undue sway'

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.

Selfish goals?

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."

Correction: In an earlier version of this story, Morningstar analyst Lawrence Jones was mistakenly identified as Lawrence White.

First Published: February 20, 2009: 12:27 PM ET"

Some Really, Really Scary Things Were Not Facing

I guess that it's all in how you see things. In the 1930s, Totalitarianism was a real possibility. It was not clear to people that Capitalism could survive in any form. For my religion, it wasn't clear any of its adherents would be alive. There were plans for a museum dedicated to its extinction. Most of the vaccines that have extended our lives weren't around. A war of tremendous loss had been recently fought, and a worse war was on the horizon. The decisions made about the economy and how to deal with it were made in that context. There is no way to meaningfully compare the decisions of the 1930s to our time except in very tenuous ways. In abstracting out some principles and policies that might help us, we are losing the most meaningful aspects that influenced those decisions. The look back at the 1930s is more like a search for a narrative similar to ours, which can give us hope that our narrative ends as well for us as did that earlier saga.

This is what I call the Existential Situation or Context or Background to our time. It is similar to the concept that Wittgenstein, Austin, Merleau-Ponty, and their modern followers use to understand Human Agency in all its facets. That's why, when reading the article on Fortune entitled "8 Really, Really Scary Predictions, I wasn't at all frightened. If the economic conditions were to lead to enormous and awful social transformations, then I'd be very worried. But, so far, I don't see that happening. Some do. But, to dip into our 1930s narrative, they are akin to the people in the 1930s who were sure that the only choice was between Communism and Fascism. The role of the individual and human agency to determine the fate of the world was lost on them, and so they only saw the world as competing systems, a competition in which Communism and Fascism were far more ruthless and cunning and therefore destined to survive at the expense of a weak and decadent Capitalism. Jot that down in your notebook for reference.

The list has a few of my favorites:
William Gross
Jim Rogers
Nouriel Roubini
and I'm going to add Robert Shiller and Meredith Whitney, who, although I've criticized them mostly on this blog, I actually like and respect. That's the Paradox Of Human Agency out of which all interesting thought arises.

First, Roubini:

"We are in the middle of a very severe recession that's going to continue through all of 2009 - the worst U.S. recession in the past 50 years. It's the bursting of a huge leveraged-up credit bubble. There's no going back, and there is no bottom to it. It was excessive in everything from subprime to prime, from credit cards to student loans, from corporate bonds to muni bonds. You name it. And it's all reversing right now in a very, very massive way. At this point it's not just a U.S. recession. All of the advanced economies are at the beginning of a hard landing. And emerging markets, beginning with China, are in a severe slowdown. So we're having a global recession and it's becoming worse."

Everything has a bottom. The point is to keep our heads and focus on what works as we try this and that policy. Roubini's view is less Pessimistic than Mechanistic, which is unusual for him.

"Sherif Ali: Truly, for some men nothing is written unless THEY write it."

William Gross:

"While 2008 will probably be best known as the year that global stock markets had their values cut in half, it was really much, much more. It was a year in which every major asset class - stocks, real estate, commodities, even high-yield bonds - suffered significant double-digit percentage losses, resulting in the destruction of over $30 trillion of paper wealth. To blame this on subprime mortgages alone would be to dismiss an era of leveraging that encompassed derivative structures of all types, embodying a belief that economic growth was always and everywhere a certainty and that asset prices never go down. As 2008 nears its conclusion, we as an investor nation have been forced to face a new reality. Wall Street and Main Street are fearful that a recession may be replaced by a near depression.

The outcome essentially depends on the ability of the Obama administration to rejuvenate capitalism's "animal spirits" by substituting the benevolent fist of government for the now invisible hand of Adam Smith. Federal spending and guarantees in the trillions of dollars will be required to fill the gap created by the deleveraging of private balance sheets. In turn, lenders and investors alike must begin to assume risk as opposed to stuffing money in modern-day investment mattresses. The process will take time. Twelve months of the Obama Nation will not be sufficient to heal the damage of a half-century's excessive leverage. The downsizing of private risk positions - replaced by government credit - will also result in reduced profit margins and a slower rate of earnings growth after the bottom is reached. "

I agree with Gross. The revival of the "animal spirits" is the key to solving our malady. We must have policies that target and fight the enormous fear and aversion to risk and the accompanying flight to safety. We should be walking, not running.

"Sherif Ali: Have you no fear, English?
T.E. Lawrence: My fear is my concern. "

Now Shiller:

"We don't currently have anywhere near the level of unemployment that we had in the 1930s, but otherwise there are many similarities between today's environment and the Great Depression, with things happening today that we haven't seen since then. First of all, there's the magnitude of the stock market's move up and down. The real (inflation-corrected) value of the S&P 500 nearly tripled from 1995 to 2000, and by November 2008 was down nearly 60% from its 2000 peak. The only other comparable event was the one in the 1920s where real stock prices more than tripled from 1924 to 1929 and then fell 80% from 1929 to 1932. Second, we've had the biggest housing bust since the Depression. Third, we've seen 0% interest rates. We've actually seen briefly negative short-term interest rates. That hasn't happened since 1941. There was a period from 1938 to 1941 when we were bouncing around at zero and sometimes negative, but that hasn't happened since.

And the list goes on: Our numbers don't go back as far as the Depression, but consumer confidence is plausibly at the lowest level since then. Volatility of the stock market in terms of percentage changes day-to-day is the highest since the Depression. In October 2008 we saw the biggest drop in consumer prices in one month since April 1938. Another thing is that it's a worldwide event, as it was in the Depression.

I'm optimistic that we'll do better this time, but I'm worried that we're vulnerable. One of the lessons from the Depression is that things can smolder for a long time. What I'm worried about right now is that our confidence has been hurt, and that's difficult to restore. No matter what we do, we're trying to deal with a psychological phenomenon. So the Fed can cut interest rates and purchase asset-backed securities, but that only works in really restoring full prosperity if people believe that we're back again. That's a little hard to manage."

I agree completely, of course, that we're dealing primarily with a psychological or human agency problem. Our focus and policies should focus on that.

"[Lawrence has just extinguished a match between his thumb and forefinger. William Potter surreptitiously attempts the same]
William Potter: Ooh! It damn well 'urts!
T.E. Lawrence: Certainly it hurts.
Officer: What's the trick then?
T.E. Lawrence: The trick, William Potter, is not minding that it hurts."

Now Jim Rogers:

"We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it's historic doesn't make it any more fun, of course. But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.

Virtually the only asset class I know where the fundamentals are not impaired - in fact, where they are actually improving - is commodities. Farmers cannot get a loan to buy fertilizer right now. Nobody's going to get a loan to open a zinc or a lead mine. Meanwhile, every day the supply of commodities shrinks more and more. Nobody can invest in productive capacity, even if he wants to. You're going to see gigantic shortages developing over the next few years. The inventories of food worldwide are already at the lowest levels they've been in 50 years. This may turn into the Great Depression II. But if and when we come out of this, commodities are going to lead the way, just as they did in the 1970s when everything was a disaster and commodities went through the roof."

I have said over and over that, just as on the trip up, people were disregarding the fundamentals, so they are doing on the way down. We need to be able to see more clearly.

"Prince Feisal: Gasim's time has come, Lawrence. It is written.
T.E. Lawrence: Nothing is written.
Sherif Ali: You will not be at Aqaba, English! Go back, blasphemer... but you will not be at Aqaba!
T.E. Lawrence: I shall be at Aqaba. That, IS written.
[pointing to forehead]
T.E. Lawrence: In here. "

Now Meredith Whitney:

"What the federal government has done so far- with TARP, bailing out Citigroup, etc. - has stemmed the bleeding, but what it hasn't done is fundamentally alter the landscape. Yes, there's been a tremendous amount of capital thrown into the system, but my concern is that it's just going to plug the holes. It's not going to create new liquidity, which is what the system so desperately needs.

When the government announces these plans, investors get excited and hopeful. But details have been slim, and while I appreciate the government saying, "We've been wrong here. Let's try something different," the strategy changes have not solved anything. So far we've had TARP 1.0, TARP 2.0, and TARP 3.0, and I'm certain there will be a 4.0, a 5.0, and a 6.0. There has to be, because the companies cannot raise the capital they need, which means that the default provider of capital has to be the federal government.

What happens in 2009? Frankly, it's hard for me to predict what's going to happen next week, never mind next year. What I will say is that I expect all these banks to be back in the market looking for more capital. We'll also have a wholesale restructuring of our banking system, probably toward the end of 2009. There will be banks getting smaller, banks going away, and banks consolidating. At the same time, though, I think you'll see more new banks created. We've already seen more applications. And it's a great idea: You start with a clean balance sheet and make loans today with today's information. Plus, right now you've got a yield curve that's good for lending."

A very pragamtic and sensible approach. And I agree with her about the banks.

Let's throw in a few more points. Wilbur Ross:

"We are clearly in a serious recession, and more aggressive action is needed to turn things around. The federal government initially underestimated the scale of the mortgage and housing crises and later panicked into an ever-changing series of ad hoc measures that at best dealt with some of the effects of the original crises. But homeowners have now lost $5 trillion, and 12 million families have mortgages in excess of the value of their homes. Therefore the economy will not stabilize until mortgages are adjusted down to the value of homes, with affordable payment schedules, and until new mortgages become available across the home-price spectrum. Till then, the poverty effect of falling house prices and unemployment moving up toward 7% will hold consumer spending back from its former 70% contribution to our economy.

I'm optimistic about the choices that President-elect Obama has made for his economic team, and I've got some suggestions for what they should do. Hopefully the new Treasury Secretary, Tim Geithner, will incentivize lenders to restructure mortgages by guaranteeing half of the reduced principal amount and sharing among the government, homeowners, and lenders any subsequent appreciation. Lenders would gain liquidity by selling the Treasury-guaranteed portion of the loan, and government would receive annual insurance premiums to further protect it against loss. That would cost taxpayers nothing now and probably little or nothing in the future.

Addressing unemployment is paramount. Detroit needs government support in order to implement independently verified concessions from all stakeholders - not just labor - which are sufficiently large to permit profitable operations even if auto sales remain as low as 11 million cars per year. A pre-negotiated bankruptcy may be necessary in order to implement the restructuring, but both the industry and the economy are too fragile to withstand the domino effect that a free-fall bankruptcy would have on a car company, its dealers, and its suppliers.

In addition, to avoid reversal of the 242,000 jobs created by state and local governments in the past 12 months, Washington should provide or guarantee funding for sorely needed infrastructure projects that would create immediate construction jobs and meaningful amounts of permanent jobs.

If President Obama promptly and decisively resolves these problems, whether or not he adopts my recommendations, and restores public confidence, he can end the recession by early 2010. If not, the economy will languish for a long time. Given the economic uncertainty, investors who are too worried to buy equities might consider tax-exempt bonds with yields around 6%, equivalent to almost 10% before federal, state, and local taxes."

I like this response. It seems politically very close to my own, and he also focuses on the ad hoc nature of the government's response.

"Prince Feisal: You, I suspect, are chief architect of this compromise. What do you think?
Mr. Dryden: Me, your Highness? On the whole, I wish I'd stayed in Tunbridge Wells. "

John Train:

"I presume that although we are in a severe recession it will not decompose into a full-scale depression, because that is what everyone is afraid of and desperate to avoid. Wall Street likes to say that the market has anticipated five of the last three recessions - the point being that a market crash frightens the authorities into taking necessary action.

Keynes observed that pragmatic businessmen often could not imagine that they were the slaves of defunct economists, but ironically, never is this more true than today of Keynes himself. So we run a huge deficit to postpone the worst. That means inflation, so bonds are unsatisfactory.

Investment opportunity is the difference between the reality and the perception. And since many equities are priced as though a depression might be on the way, many of them are attractively priced."

The difference between perception and reality. Another epistemologist manque. I agree. That's basically the problem. We need to learn to see again.

"Auda abu Tayi: [as Lawrence sets out across the desert with Daoud and Faraj] You will cross Sinai?
T.E. Lawrence: Moses did!
Auda abu Tayi: And you will take the children?
T.E. Lawrence: Moses did! "

Sheila Bair:

"The private-label mortgage-backed securitization markets are a prime example. Trillions of dollars of investor money funded millions of mortgages that borrowers had little chance of repaying. Investors relied heavily on ratings agencies, which in turn relied too heavily on mathematical models instead of analyzing the underlying loans. To be sure, borrowers, brokers, lenders, securitizers, as well as state and federal regulators, all bear responsibility for the widespread deterioration in lending standards. But the problem was compounded by the fact that those ultimately holding the risk - the investors - did not look behind their investments at the quality of the mortgages themselves. If they had, they would have seen high loan-to-value ratios, little income documentation, burdensome fees, and steep payment resets. They would have seen mortgages unaffordable from the beginning, originated based on the assumption that home prices would continue to rise and borrowers would refinance. Of course, we now know that as home prices began to depreciate, borrowers were unable to refinance, leading to massive foreclosures and further price declines. This self-reinforcing downward spiral is at the core of the economic problems we face today.

We will dig out of this. And when we do, I hope for a back-to-basics society - where banks and other lending institutions promote real growth and long-term value for the economy, and where American families have rediscovered the peace of mind of financial security achieved through saving and investing wisely. We need to return to the culture of thrift that my mother and her generation learned the hard way through years of hardship and deprivation. Those are lessons learned that the current crisis is teaching us again."

This is all true. It was actual human decisions that caused the mess. What we need to do is find the presuppositions that they were working under and whether their actions are something worse than lack of foresight and stupidity.

"Club Secretary: I say, Lawrence. You are a clown!
T.E. Lawrence: We can't all be lion tamers. "

Did you find this all that scary? Troubling and needing a mountain of compassion and hard work, but not necessarily scary. Imagine no FDIC at all.

So, that's my take. And, paradoxically, I used the example of British actions in WW I which can be said to have led to many of our current maladies worldwide.

"T.E. Lawrence: The truth is: I'm an ordinary man. You might've told me that, Dryden. "