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.
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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.
(Read more: Pimco:Three reasons why bond investors have to chill)
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.
(Read more: 'Lots of opportunities' in market: Pimco CEO)
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.