Key to economic recovery may be in California

The credit crunch rolled from the East Coast across America like a tidal wave. But the U.S. is about to be whipsawed by a riptide rolling back from Southern California.

Best known for its celebrities and beaches, the region also is an enclave of the world's largest and most influential bond fund managers. And it will be these bond fund managers and their decisions of how to use their massive pools of cash to buy that will determine in large part when the credit crisis ends and the bond market stabilizes.

These firms are expected to be key players in the government's efforts to auction off many of the mortgage-related assets that have gummed up credit markets, necessary to get money flowing to companies, home buyers and entrepreneurs.

Southern California bond firms "are going to be enormously influential in both the methodology of tomorrow for bonds and in the actual construction of the markets," says Cynthia Steer of investment consulting firm Rogers Casey. "There's no question their influence is giant and deep-seated."

The size and influence of Southern California's bond investors and their importance in helping mend battered U.S. financial markets is evident from the fact it is home to:

•The largest buyers of bonds for institutions. Two of the three largest institutional bond investment managers are in Southern California, namely Pimco in Newport Beach and Western Asset in Pasadena, according to Institutional Investor. Pimco is the U.S. bond operation of Allianz Global, and Western Asset is the bond operation of Legg Mason. The two combined run more than $750 billion for large U.S. institutions, such as pension plans and endowments. The other of the Big 3 is New York's BlackRock.

•The largest buyers of bonds for individuals. That includes two of the three largest bond mutual funds: Pimco's Total Return is No. 1 followed by No. 3 Los Angeles-based American Funds' Bond Fund of America, says Morningstar. Vanguard's Total Bond Market Index is No. 2.

•The most skilled firms. All of the past five top fixed-income managers are from firms based in Southern California, going by the widely watched Fixed Income Manager of the Year award from industry tracker Morningstar. Thomas Atteberry and Robert Rodriguez of Los Angeles-based First Pacific Advisors won the award for 2008, following managers at Pimco in 2007, TCW in 2006 and Metropolitan West in 2005.

So while bonds are largely created and sold from New York, much of the buying is by the Southern Californian behemoths.

Why California has turned into such a bond-buying powerhouse is unclear. Some chalk up it up to randomness. Others say many of the junk-bond experts who moved to Beverly Hills along with former junk-bond king Michael Milken in the 1980s created a bank of expertise in the region.

Others are more cynical. TCW's Jeffrey Gundlach, widely recognized for spotting and vocally warning of the credit bubble, says the area's advantage is that it's about the farthest you can get from the sales pitches of the New York firms that make a living selling the debt instruments. "If you buy into the myths and lies of Wall Street, you will be a poor bond investor," he says.

The credit crisis, though, has created discord in this usual slow-and-steady crew. Some top players are criticizing rivals' tactics. And for the first time in years, different strategies applied by managers are leading to large performance gaps. Several bond firms in the area turned in mixed performances last year, a few losing 10% or more. Some better performers smell blood, hoping clients will defect from the larger firms.

TCW's Gundlach says some of the larger bond firms have exposed their clients to outsize risks by playing in the bond derivatives market. Some of these firms placed complicated trades binding them to buy bonds at preset prices in the future. By using these contracts, rather than buying bonds outright with cash, some managers boosted short-term returns by taking on additional risk, he says.

Investors, stunned by their losses last year, will likely move their money from larger firms that bet wrongly on these derivatives, Gundlach says. "How can you not give up on them? They're supposed to be credit experts."

Western Asset's Ken Leech, who was chief investment officer until taking medical leave last year, doesn't deny the year was tough. But Leech, now working as a strategy adviser for Western, says the firm has the experience to navigate through the crisis. And while the firm uses derivatives, he says they're common in the industry, and they can allow clients to benefit from corners of the bond market that normally would be too small to dabble with.

Meanwhile, the region's bond investors are braced for what could be an even more difficult year in 2009. Being too aggressive could lead to another big year of losses. But being too cautious could mean missing out on historically high yields and seemingly once-in-a-lifetime prices. "A lot of pension funds and endowments are in a state of shock," says Rodriguez, who, despite his fame as a conservative bond investor, races Porsches on the weekends. "This year will be much more challenging."