Pimco's Gross Talks Tough on Subprime Threat

Smart Money reports:

Whose word would you trust on matters subprime - leading monetary authorities, or one of the bond market's top players?

They're in strong disagreement, judging by the latest report from Pimco chief Bill Gross.

The head of the world's largest bond fund has warned investors not to be placated by the Federal Reserve's view that capital markets are well-insulated from the fallout from mortgage defaults. Pimco is a unit of Allianz SE (AZ).

The ratings agencies' sweeping downgrades of debt deals tied to the subprime mortgage market over the past month has undermined the confidence of lenders, Gross says. As a result, they are rethinking the generosity that for so long allowed borrowers to get away with offering low yields and almost no protection on their principle.

Gross points out that tougher borrowing conditions are bad news not only for the credit market - where premiums are on the rise and new deals are stalling - but for stocks and the economy as a whole.

"The sudden liquidity crisis in the high-yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy," Gross wrote.

His theory contrasts sharply with the latest statements from Federal Reserve officials.

Only last week, St. Louis Federal Reserve President William Poole told reporters that, "as best I can tell, the problems should remain isolated (to the subprime market)."

"Because bank capital is strong and bank involvement is relatively limited, it's much less likely problems could spread," the central banker said.

A few days earlier, Federal Reserve Chairman Ben Bernanke wasn't staking his reputation on a similar prognosis, but he was prepared to put a figure on losses of between $50 billion and $100 billion.

Indeed, Gross says the current credit market repricing has been more radical than any monetary tightening.

"The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half's time as has occurred in the high-yield market," he wrote.

The ability to pay off debt is becoming an issue.Interest rates are going higher even if the economy weakens.