Subject: Pimco Makes $8.1 Billion Bet Against ‘Lost Decade’ of Deflation - Bloomberg
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Date: Wed, 15 Sep 2010 08:54:14 -0400

Pimco Makes $8.1 Billion Bet Against ‘Lost Decade’ of Deflation
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By Miles Weiss

Sept. 15 (Bloomberg) -- Bill Gross’s Pacific Investment Management Co.  
made an $8.1 billion wager that the U.S. won’t suffer a decade of  
deflation like the one that crippled Japan starting in the 1990s.

That’s the notional value of long-term derivative contracts tied to  
the U.S.consumer price index that Pimco’s mutual funds entered into  
during the first half of this year, according to a regulatory filing.  
The funds received $70.5 million in up-front premiums under these  
contracts, known as inflation floors, in return for agreeing to pay  
investors should prices decline in the 10 years ending in 2020.

“We think the possibility that the U.S. goes 10 years with stagnant or  
falling prices is remote,” Mihir Worah, the head of Pimco’s real  
return portfolio management team, said in an e- mailed response to  
questions. “The options were priced at rich levels to the underlying”  
risk, added Worah, whose funds invest in Treasury inflation protected  
securities.

The cost of protecting against deflation has doubled since January as  
signs of an economic slowdown in the U.S. prompted investors including  
Canadian insurer Fairfax Financial Holdings Ltd. to buy the  
derivatives. James Bullard, president of the Federal Reserve Bank of  
St. Louis, said the U.S. could suffer the same type of economic  
malaise as Japan. Pimco Chief Executive Officer Mohamed El-Erian said  
last month the chance of deflation in the U.S. is around 25 percent.

‘New Normal’

El-Erian has been among the most outspoken proponents of a theory  
forecasting years of below-average economic growth, elevated  
unemployment and a decreasing dominance of the U.S. in the global  
economy. While falling prices are not his main scenario in that  
outlook, named “new normal,” El-Erian has argued that increased fear  
of deflation may have been one reason for recent sell-offs in  
financial markets such as the 2.8 percent decline in the Standard &  
Poor’s 500 on Aug. 11.

Pimco disclosed in a June filing that its funds began writing 10-year  
inflation floors during March and reported last month that they issued  
additional contracts in April. According to the Aug. 27 filing with  
the U.S. Securities and Exchange Commission, 25 Pimco funds entered  
into these inflation floors during this year’s first half, with  
Gross’s $247.9 billion Pimco Total Return fund accounting for $6.57  
billion of the $8.1 billion total.

Premiums from the contracts help boost fund income as yields on  
government bonds are near record lows. Potential losses are limited  
because the fixed-income securities that account for a majority of the  
$1.1 trillion the Newport Beach, California, firm oversees would  
probably gain in value if consumer prices had a protracted decline.

‘High-Severity Outcome’

“Falling or lower inflation than we have today on a steady basis is  
the bond market’s greatest friend,” said David Ader, the head of  
government bond strategy at CRT Capital Group LLC, a Stamford,  
Connecticut, broker-dealer. “First and foremost, it would make  
government debt very valuable, because you know they will pay you back.”

Inflation floors, structured as options on the consumer price index  
for all urban consumers, are similar to insurance. The buyer of the  
contract pays a premium at the outset in return for the right to  
receive a payment after 10 years should the CPI decline during this  
period, according to D’Arcy Miell, global head of inflation products  
at BGC Partners LP, a New York-based inter-dealer broker.

The size of the payment would be calculated by multiplying the  
cumulative percentage decline in the consumer price index with the  
face value or ‘notional’ amount of the contracts, said Mark Greenwood,  
head of inflation options in the London office of Royal Bank of  
Scotland Group Plc.

Pimco’s Wager

In Pimco’s case, a cumulative 10 percent decline in the price index  
over 10 years would require the funds to pay out a total of about $810  
million, based on that formula. The funds would pay nothing to the  
counterparties and keep the premiums if prices in 2020 are equal to or  
higher than in December 2009 or January 2010, depending on the  
contracts.

“This is obviously a very low-frequency, high-severity event,”  
Greenwood said. “Investors fear deflation, but most ascribe a low  
probability to it.”

Worah said Pimco’s inflation floors are “analogous” to the $36 billion  
of equity index put options that Warren Buffett’s Berkshire Hathaway  
Inc. has on major stock market indexes, including the S&P 500.  
Berkshire received $4.9 billion in derivative premiums in return for  
agreeing to make payments to the counterparties, starting in 2018, if  
the stock indexes are lower than when the contracts were signed.

Deflation Fear

With U.S. unemployment stuck near 10 percent and consumer prices  
rising just 1.2 percent for the 12 months ended in July, investors  
have been seeking financial products that would protect their holdings  
from deflation. Canadian insurer Fairfax Financial Holdings said in  
July that it bought 10-year contracts tied to consumer price indexes  
with a face value of $21.5 billion in this year’s first half.

The price of 10-year inflation floors has risen to 146 basis points,  
or 1.46 percent of the face value of each contract, from an average of  
78 basis points in March and as little as 42 basis points in October,  
according to data compiled by Bloomberg.

Pimco on average received about 87 basis points, according to the  
premiums reported in its filing. Premiums on 10-year inflation floors  
equaled about 108 basis points at June 30.

“We have seen tremendous growth since the end of last year, less so in  
inflation caps and more so in floors,” said Allan Levin, head of  
structured rates for North America at Deutsche Bank Securities Inc. in  
New York. “It reflects an increasing fear of deflation.”

‘Lost Decade’

As recently as April, Pimco’s Worah wrote that inflation, not  
deflation, was the primary long-term concern in the U.S., given that  
the federal government could choose to address widening budget  
deficits by devaluing the dollar. Scott Mather, Pimco’s head of global  
portfolio management, wrote in August that the odds had increased of  
the U.S. suffering a Japanese- style “lost decade.”

“If you have inflation going down toward zero, you enter a new regime  
where expectations can become a self-fulfilling prophecy,” Mather said  
in an interview. “That is what we saw in Japan as well,” he said,  
referring to an era of declining real estate and equity prices that  
began in the early 1990s.

While the derivative contracts suggest that deflation fears have  
increased, the risk of deflation in the U.S. is lower than it was in  
Japan because the two countries have different currency policies, said  
Donald Ratajczak, an economic consultant and former director of the  
Economic Forecasting Center at Georgia State University.

‘Bad Bet’

Japanese deflation stems from government policies to maintain the  
value of the yen that depleted the money supply there, said Ratajczak,  
who won acclaim from the Boston Federal Reserve Bank for his inflation  
forecast in the 1990s.

“We don’t care as much about our dollar,” said Ratajczak. “People who  
are betting on ten years of deflation are making a bad bet.”

Wall Street dealers write derivative contracts for clients that want  
to bet on or protect their holdings from changes in interest rates,  
commodities, stock prices and other financial markets. The dealers can  
then keep the contracts, sell some of them to other Wall Street firms  
through the inter-dealer market, or find counterparties such as Pimco  
that will take the other side of the trade.

The value of inflation floors traded between dealers doubled to $3  
billion in the first half of this year, from $1.5 billion for all of  
2009, according to Miell at BGC Partners. That’s a fraction of the  
$21.5 billion Fairfax Financial bought.

Buffett’s Model

Fairfax, based in Toronto, sells insurance and invests the premiums it  
receives in out-of-favor securities, similar to Buffett’s investment  
model. Equities are more at risk from deflation than fixed income  
securities such as the Treasury bonds Pimco holds in its funds, and  
which gain in value as interest rates decline.

Given the size of the inflation floors bought by Fairfax Financial,  
Pimco may have taken the other side on some of them, said Greenwood.

Paul Rivett, Fairfax Financial’s chief legal officer, declined to  
comment on the counterparties to the contracts.

“We are very concerned about deflation and have put this trade on to  
hedge some of what we see as a not insignificant risk,” Rivett said in  
an e-mail. “Unfortunately, we have not publicly disclosed the inner  
mechanics of the trade.”

To contact the reporter on this story: Miles Weiss in Washington [email-masked]