By way of background, Bill Gross is something of a legend in the fixed income world. He founded Pimco, one of the biggest and most highly respected fixed income firms, with nearly $700 billion under management. Gross is also its chief investment officer and is considered very savvy (and as important for the purposes of this post, is not a bear by temperament).
Gross has been increasingly alarmed about the outlook for the markets, and in a Bloomberg story,”CDOs in `Hooker Heels’ Fool Moody’s, S&P, Gross Says,” he warns that he expects investors in even some investment grade CDOs to lose all their investors’ money.
That’s a grim forecast. Hedge funds have invested heavily in CDOs, as have some pension funds. Look at the disruption the collapse of two Bear hedge funds have created, due to the fact that Wall Street firms (via their prime brokerage operations) lend against hedge fund assets, including CDOs. A collapse in CDO prices would deliver major losses to Wall Street. And if a big firm failed, or needed to be rescued, that alone could set off the systemic failure that regulators are increasingly worried about (see here and here).
Moreover, CDOs often buy the risky tranches (the so called equity tranche) in mortgage backed securities. Selling mortgage backed securities has become an integral part of mortgage finance (for the most part, banks no longer keep mortgages on their books; they sell them to warehouses that package them into securities, freeing up capital so they can make more loans). But it turns out these MBS sales require that the equity tranche be sold first. If CDOs fall out of fashion,it will impair MBS issuance, which means higher mortgage interest rates, which will further damage the housing market.
To Bloomberg:
Moody’s Investors Service and Standard & Poor’s were duped by the make-up and “six-inch hooker heels” of collateralized debt obligations they gave investment-grade ratings, and investors now stand to lose all their money, according to Bill Gross, manager of the world’s biggest bond fund.
Subprime mortgage bonds made up about $100 billion of the $375 billion of CDOs sold in the U.S. in 2006, Moody’s and Morgan Stanley data show. CDO’s are created by bankers and money managers who bundle together securities and divide them into slices with credit ratings as high as AAA.
With defaults on those subprime loans rising, buyers of the BBB pieces of some CDOs stand to lose their entire investment, said Gross, chief investment officer at Pacific Investment Management Co. Gross manages the $103 billion flagship PIMCO Total Return Fund in Newport Beach, California.
“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels and a `tramp stamp,”’ Gross said in his monthly commentary posted on Pimco’s Web site today. “Many of these good looking girls are not high-class assets worth 100 cents on the dollar.”
Subprime mortgages are loans made to borrowers with poor or limited credit histories, or high debt burdens. Mortgages at banks with past due payments are the highest since 1994, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at 8,650 U.S. financial institutions.
`Like a Weed’
Defaults on subprime loans will “grow and grow like a weed in your backyard tomato patch” and if total losses reach 10 percent, CDO slices rated A may also “face the grim reaper,” Gross said.
Christopher Atkins, spokesman for S&P in New York, declined to comment. Frances Laserson, spokeswoman for Moody’s in New York, declined to immediately comment.
The credit rating companies “were downgrading hundreds of these CDO structures in the last few weeks and that is an early indication of being fooled,” Gross said in an interview today. “We can see certain structures rated investment-grade losing much or most of their money over the next six or 12 months.”
At least 60 mortgage companies have halted operations, gone bankrupt or sought buyers since the start of 2006, according to Bloomberg data. Irvine, California-based New Century Financial Corp. and ResMae Mortgage Corp. of Brea, California, were forced into bankruptcy. UBS AG, Switzerland’s biggest bank, shut down its Dillon Read Capital Management LLC hedge fund unit after losses linked to turmoil in the mortgage-bond market.
Bear Bailout
New York-based Bear Stearns Cos. is working to bail out two money-losing hedge funds it runs that invested in CDOs backed by subprime mortgage bonds.
Pimco bid on securities auctioned off by the failing Bear Stearns funds and its creditors because not all of them are of poor quality, Gross said in the interview. Pimco had $10 billion in CDO assets, based on face value, as of March 31, 2006, according to an S&P report from last June.
“Those that point to a crisis averted and a return to normalcy are really looking for contagion in all the wrong places,” Gross said. “Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford and yes, the naked — and empty — rows of multistoried condos in Miami.”
Fed Cut?
Gross maintains his prediction the Federal Reserve will cut its target interest rate in the next six months as a slowdown in the housing market causes risk premiums to rise and the U.S. economy to slow. Gross said in October that slowing U.S. growth would prompt the Fed to lower rates in the first half of this year. The Fed has kept the benchmark rate at 5.25 percent for the past year.
The Pimco Total Return Fund returned 0.5 percent through May of this year, underperforming its benchmark, the Lehman Brothers Aggregate Bond Index, by 0.8 percentage points, according to Morningstar Inc. data.
Sales of previously owned homes in the U.S. fell in May to the lowest in almost four years, the National Association of Realtors said yesterday. The median sale price of an existing home fell 2.1 percent to $223,700 in May from a year earlier, the 10th straight month of year-over-year declines, the group said.
“The willingness to extend credit in other areas — high yield, bank loans and even certain segments of the AAA asset- backed commercial paper market — should feel the cooling Arctic winds of a liquidity constriction,” Gross said.
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I read somewhere that the genesis of the Bear fiasco was the lenders to the fund. They declared they wanted more collateral which caused Bear to reprice which caused redemptions which caused margin calls.