The $1.7 Billion Payday: How Bill Gross Made a Killing on the Bailout

As we saw earlier, Bill Miller and Legg Mason (LM) may have lost a cool billion on the Fannie (FNM) and Freddie (FRE) bailout. But someone else made a killing. Here’s how...

As we saw on Wednesday, you had a lot to say on the Bill Miller / Freddie Mac debacle.

A few of you took up the conspiracy angle (which I didn’t find time to address):

I always wonder what is behind the scenes on things of this nature. Why was Bill Miller set up to be the fall guy? Or was he? How much REAL power did he have over the situation? Or did he have any?
-- TD Reader Bonnie M.

My bet would be that [Miller] had an inside man who assured him he was in a winning position. When politics got involved, his man couldn't deliver and he got hung out to blow in the wind.
-- TD Reader S.

Oh, you can bet politics were involved... and those who played their cards right made a killing. Miller just happened to be the fish at the table this time around. (You know that old poker saying: “If you’ve been sitting at the table for an hour and still don’t know who the fish is... then the fish be you.”)

When it comes to reading the tea leaves, Bill Gross was the true virtuoso. He’s the guy whose fund made $1.7 billion in a single day off the Fan and Fred bailout... even as Miller and Legg Mason lost their shirts.

How did Gross do it? He loaded up on debt rather than equity. Gross knew full well that while the Fannie and Freddie stockholders would get screwed, the bondholders would be saved.

Let me explain a little more…

Bill Gross (a.k.a. “the Bond King”) is the manager of the Pimco Total Return fund, a whopping monster of a bond fund with more than $130 billion in assets.

Over the first six months of the year, Gross had moved more than 60% of his fund -- close to $80 billion -- into mortgage debt. What did Gross know that Miller didn’t? He knew that, come what may, mortgage-backed bond holders would have to be bailed out, no matter what... because of the global politics of who else owns that mortgage debt.

For example, guess who was sitting on a massive $15-20 billion pile of FNM and FRE debt as recently as June?

The Bank of China.

It has sold off a good chunk since then, but that’s just one Chinese bank -- and just the tip of the iceberg as far as Chinese financial institutions loading the boat.

Last year, according to Reuters, China on the whole had accumulated as much as $376 billion worth of U.S. “agency” debt -- meaning the bonds of federal-related outfits like Ginnie Mae, Fannie Mae and Freddie Mac.

The upshot is, Treasury Secretary Paulson was happy to make an example out of equity investors like Miller, who knew they were taking a big risk in pursuit of a big return.

But no way, no how was Paulson about to blow out the holdings of one of America’s top creditors (China).

By some estimates, China has now amassed as much as $1.6 trillion in foreign reserves, with more than two-thirds of that parked in U.S. debt instruments (agency debt, treasury bonds and so on). Burn those guys in a bailout plan? You’ve got to be kidding. Fiscally speaking, that would be like shooting ourselves in the foot with a machine gun.

So Gross had a pretty good lock on the situation. He knew it was sharp to align his interests with China’s. And to further ensure a positive outcome, the Bond King took every opportunity by ranting and raving from his soapbox -- a mighty big soap box -- about how government should be on the lookout for mortgage holders, and how letting mortgage owners suffer would be a travesty.

When news came out that the Fannie and Freddie debt holders would indeed be kept whole (as China demanded and Gross knew would happen), the value of those debt holdings soared, giving Gross a $1.7 billion pop in the value of his fund.

It was a bailout done right in the sense of protecting the players that mattered... and making an example of the ones who didn’t. (Whether it was right in moral or strategic terms is a whole other kettle of fish.)

The lesson? If you’re going to play the game for ultra-high stakes, you have to know the players at the table and what they’re about. Gross did. Miller didn’t.

On a related note, these thoughts of conspiracy and backroom dealings got me thinking: Where is the plunge protection team?

We’ll dig into that question next week... and I’ll share my controversial thoughts with you in full. 

Stock position: None.

Comments

[Ransome:]

During the Long Depression, when money became scarce, it was said stocks were for Rubes. Different economic times, perhaps.

2008 Sep 14 09:02 AM

[michael55555:]

Wasn't it the shorts that did the best? I'm not a huge fan of conspiracy theories, but why is one arm of the government (the Fed and the Treasury) doing everything they can to calm the capital markets while another arm (the SEC) is effectively working against them with their very accommodating rules for short selling? Or, could it be that the SEC being complaisant to shorts while the Fed and the Treasury are stepping in to finish off the job?

2008 Sep 14 09:48 AM

[vanyali:]

I don't really see how swooping in to wipe out shareholders is supposed to calm markets, but what do I know?

2008 Sep 14 10:06 AM

[purestock:]

this article explains in succinct terms the most basic fact of real existing global corporate capitalism: power determines markets whenever markets fail to operate in a relatively stable manner. clearly, the global economic power system now includes not just the G7 led by the USA and Western Europe, but China and energy powers like the Saudis and other Gulf Sheikdoms. The dollar remains the currency of choice for the Oil Sheikdoms, and China needs a stable USA to maintain its global growth machine. Those who hold US Debt must be protected at all costs. And that debt is primarily Mortgages and Federal Deficits. On the horizon looms US consumer debt. Who pays for the protection of our New Global Lenders?

The US taxpayer will continue to experience a decline in their real standard of living as government pays a growing percentage of its collected taxes on debt and interest, and as the cost of importing energy continues to rise. When combined with high rates of inflation in health care, higher education, and food over the past few decades, the relatively flat or declining wages of the average american means we will continue to experience growing inequality inside the USA, as a small number of elite professionals and corporate managers benefit from the selling off of America's present and future assets and earnings to protect the new global corporate system.

Most american corporations doing well have done so through their connection to the federal budget (defense and security) or by expanding rapidly overseas.

when companies restructure their operations in the usa, almost always we see plants being shut down in europe and north america while plans for continued expansion move forward in asian labor markets.

the only growth strategy in the usa for the future will be in new energy infrastructure, massive cuts in health care costs freeing tax and consumer monies for education, housing and food, and a redistribution from global militarism to domestic social and economic security through expansion of public goods in health, education, and social welfare programs, including world class parks and recreation facilities accessible to all.

until we get real about what has been happening in this country led by the wall street snakeoil salesmen and their political allies, we will continue to see massive capital investment in speculative bubbles having nothing to do with the efficient deployment of capital in a free market system.

2008 Sep 14 11:07 AM

[liongterm i...:]

The real point that you make is that the same people that created and invested in the low quality debt have been provided an incentive to go out and try again.

The Treasury should have offered the debt holders 20 cents on the dollar along with diluting the shareholders 5 to 1. This was in no way a bailout of the shareholders, but a bailout of sophisticated debt investors that understood how to game the system. This includes the US Treasury who protected their own ability to access capital cheaply.

2008 Sep 14 01:15 PM

[kurt walter:]

Bill Gross has been on TV talking up the Fannie and Freddie bailout because he needed it badly to survive.

2008 Sep 15 07:19 PM