Bond guru Bill Gross says the government must move in support of home prices to make sure the credit markets don’t melt down.
Gross manages Pacific Investment Management Co.’s Total Return Fund, the world’s biggest bond fund. Gross has increased his weighting of mortgage debt to the highest level since 2000, betting against Treasuries in the biggest way since at least that year.
In his April letter to investors, Gross blasts his competitors in the credit markets.
"In my opinion, the private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence, excessive greed, and in minor instances, fraudulent activities,” he writes.
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"As a result, the deflating private market’s balance sheet is being re-nationalized, in some cases with increased regulation, in others with outright guarantees and agency lending.
"Ultimately, government programs which support private credit market assets may be required in order to prevent an asset deflation of significant proportions.”
Translation: the government must act to lift home prices — and quickly.
"Since homes are the most highly levered and monetarily significant asset that American consumers own, if they decline much further, they will drag the rest of the economy with them,” Gross argues.
"Home price declines of 20 percent are in fact much more of a shock to the American economy than the popping of the Internet bubble and the NASDAQ 5000, because the amount of homeowner leverage is so much greater.”
Bottom line, according to Gross: "The [home price] decline needs to be stopped quickly to avert additional crises.”
As for inflation, it’s likely headed higher thanks to the Federal Reserve’s bailout of investment bank Bear Stearns and opening of its discount window for investment banks, he writes.
"Because of this lender-of-last-resort operation, subsequent inflationary trends may have been fertilized, because the debts that caused the crisis are now primarily in another private portfolio [J.P. Morgan’s] and not liquidated (the Fed having absorbed only 10 percent of the collateral).”
To keep this debt from going bad, Gross argues, the Fed will have to inject liquidity into the financial system.
"Which is another way of saying they are trying to reflate, which is another way of forecasting an increasing probability of higher inflation,” he said in a note to investors.
As for Pimco Total Return, Gross increased its mortgage debt to 59 percent of assets in March, up from 52 percent in February and 23 percent a year earlier, Bloomberg reports.
Gross clearly sees value in the beaten-down mortgage bond sector.
"Treasuries are the most overvalued asset in the world, bar none,” Gross told CNBC..
He put the fund’s money where his mouth is, increasing positions in derivatives that will profit from a decline by Treasuries.
Pimco Total Return’s weighting in government debt was negative 18 percent in March, thanks to those short positions.
The fund returned 4.03 percent so far this year through April 9, beating all other intermediate bond funds, according to Morningstar.
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