PIMCO: Fed "can't afford" to let housing crack

NEW YORK (Reuters) - The Federal Reserve "cannot afford" to let U.S. housing prices fall sharply and will have to cut interest rates aggressively to prevent that from happening, said the manager of the world's biggest bond fund on Monday.

"A Fed cannot afford to let homes go down by 10 to 15 percent like we saw in Japan," said Bill Gross, chief investment officer of Pacific Investment Management Co. or Pimco, on CNBC Television.

Already, the housing market is facing turmoil in so-called subprime loans made to borrowers with shaky credit. Delinquencies are rising on subprime mortgages and defaults are piling up at record rates as home prices sink, pressuring consumers' desire to spend.

The turmoil in the subprime mortgage-market is a "$1 trillion problem ... there are $1 trillion worth of subprimes and Alt-As and basically garbage loans," Gross said.

He expects $250 billion of subprime and Alt-A mortgage loans to default and those defaults will fall to the balance sheets of investment stalwarts such as Merrill Lynch MER.N and Citigroup (C.N).

The problems in the mortgage market stem from subprime and Alt-A loans with adjustable rates that are suddenly resetting upwards, said Gross.

"We've only begun to see the pain from the standpoint of the homeowner in terms of those monthly payments. Defaults and delinquencies will increase as we extend throughout 2007 and then into 2008."

Gross expects the Fed to move aggressively into the new year. "Ultimately, the Fed has moved down to what we measure as a 1 percent -- or lower -- real interest rate in order to support the economy and revive it again," he said. "A 1 percent real interest rate when tacked on to a 2.0-2.5 percent inflation rate is really a 3.5 percent short-term rate. Ultimately, that's at least where they are headed."

Gross said a 3.5 percent fed-funds target rate implies that the 30-year mortgage rate comes down to 5.0-5.5 percent. "We haven't seen that yet - and that is part of the problem," Gross added.

The problems don't stop there, however.

Municipal-bond investors, he said, must make sure that the underlying foundation of their bonds are solid. "There's not a problem with solvency or default here, but there's a problem in terms of ratings," he said. "These monoline insurers that rate municipal bonds that take a single A or Baa bond to triple-A based on the insurance ... if the insurance companies are written down, then no longer do we have triple-A or double-A munis."

(Reporting by Jennifer Ablan and John Parry)