June 26, 2007 / 1:48 PM / 12 years ago

PIMCO's Gross says "subprime crisis" not isolated

NEW YORK (Reuters) - Bill Gross, manager of PIMCO, the world’s largest bond fund, said on Tuesday the subprime mortgage crisis gripping U.S. financial markets was not an isolated event and will eventually take a toll on the economy.

Gross, the chief investment officer of Pacific Investment Management Co., or PIMCO, also said in his July investment outlook that the crisis would prompt the Federal Reserve to lower the benchmark interest rate by year-end.

“To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times,” he said.

By midday on Tuesday, short-term U.S. interest rate futures were showing a roughly 36 percent chance of a quarter-percentage-point cut in the benchmark fed funds rate by the end of 2007.

That is down from a 42 percent probability early Tuesday, but up from just 2 percent on June 18, just before problems emerged at a pair of Bear Stearns Cos.’ BSC.N hedge funds.

Gross said in an interview that he had spoken with former Fed Chairman Alan Greenspan, but declined to say what had been discussed. Greenspan is an economic consultant for PIMCO.

In the newsletter, posted at the company’s Web site, he said the recent Bear Stearns hedge fund rescue was reminiscent of the Long-Term Capital Management episode nearly a decade ago.

He was referring to the August 1998 collapse of the steeply leveraged hedge fund Long-Term Capital Management, which triggered worldwide panic and ultimately led the Federal Reserve Bank of New York to broker a $3.6 billion bailout to keep financial markets stable.

“Shame on you Mr. Stearns, or whoever you were, for scaring us investors like that and moving the Blackstone (BX.N) IPO to the second page of the WSJ,” writes Gross, referring to The Wall Street Journal. “We should have had a week of revelry and celebration of levered risk-taking.”

Gross said there are hundreds of billions of dollars of subprime residential mortgage-backed securities (RMBS), derivatives on subprime RMBS and collateralized debt obligations (CDOs) that buy subprime RMBS and/or the derivatives on the RMBS — all of which he considers “toxic waste.”

“Whether or not they’re in CDOs or Bear Stearns hedge funds matter only to the extent of the timing of the unwind,” said Gross, who manages the $104 billion PIMCO Total Return Fund.

The subprime crisis “may be just what the Fed has been looking for — easy credit becoming less easy; excessive liquidity returning to more rational levels,” he added.

Nonetheless, he said he expects the Fed to issue an “insurance” policy in the form of a lower short-term interest rate over the next six months.

The Fed is expected to keep the benchmark fed funds rate steady at 5.25 percent at its next policy meeting this week.

KNOCK-ON EFFECT

Gross also said that the subprime crisis will reduce consumption and new home building in the next 12 to 18 months.

He cited a report by Bank of America that estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset higher this year by an average of over 200 basis points. In 2008, nearly $700 billion in ARMs are subject to reset, nearly 3/4 of which are subprime-rated, he added.

According to Gross, the knock-on effect of the subprime crisis will unfold in these resets and the ultimate impact they will have on the prices of homes — “the collateral that’s so critical in this asset-backed, and therefore interest-rate sensitive finance-based economy of 2007 and beyond.”

All told, Gross said he does not have an overweight position in Treasuries because “it’s hard to be since government bonds are owned primarily by foreign central banks.”

Instead, he said he has an overweight position in the swaps markets, “which are one notch below agencies in terms of the credit chain.”

Earlier this month, Gross conceded that the snappy pace of global economic growth will likely keep bonds on their heels.

Gross forecast that benchmark Treasury yields will range higher than previously expected, which prompted him to acknowledge he is now a “bear market manager” after a quarter-century as the global bond market’s most powerful bull.

Solid global growth and a mild acceleration of inflation in the United States and global economy will drive 10-year Treasury yields to top out at 6.5 percent over the next three to five years as opposed to the 5.5 percent ceiling previously forecast, Gross said.

Additional reporting by John Parry

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