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Bond Manager Says Don't Bail Out Subprime

Brett Arends

The question right now is whether his words always match his reputation.

Last week, Gross grabbed the headlines by warning that the housing slump could lead to devastating economic consequences. He argued that a 10% fall in prices nationwide could set off price deflation of a kind not seen since the Great Depression, while waves of mortgage defaults could undermine confidence in the financial system here and abroad.

Gross concluded by urging President Bush to launch an emergency, New Deal-style federal bailout of distressed homeowners to forestall disaster.

For an alternative view, you could talk to a less well-known bond guy, like Tom Atteberry. He's the co-manager of the $1.75 billion (CRF)First Pacific Advisors New Income (FPNIX) fund. His offices, in Los Angeles, are a short drive from Gross' suite in Newport Beach.

Atteberry certainly doesn't question the depth or scale of the housing slump. He believes the market could keep falling well through next year. He successfully kept his fund clear of risky mortgage-backed paper, and he warns that it is still "too early" to start bargain-hunting.

The history of past crises leads him to believe that that moment may not come until later this fall, some time between October and December.

He also believes the next shoe is likely to drop next month, when distressed hedge funds will be forced to sell securities in order to raise cash to meet redemptions at the Sept. 30 quarter-end. How much forced selling there is, and what effect that will have overall on the market, remains to be seen.

But here is where Atteberry parts company from Gross.

Nationwide house price deflation? Atteberry cites Wall Street research that more than half of mortgages to subprime and Alt-A borrowers -- or those with less than stellar credit and those who have good credit but are merely overstretched -- are concentrated in just a few real estate hotspots. They're the obvious places: the areas around San Francisco Bay, Los Angeles and San Diego, Sacramento, Seattle, Denver, Las Vegas, Phoenix, Houston, Chicago, Atlanta, Miami, Fort Lauderdale, Washington D.C., New York City and Long Island.

More than half.

Those same areas are also the ones that saw prices double, or even triple, during the housing bubble. Atteberry believes that prices in these areas might now fall by 30% while remaining broadly flat everywhere else.

Anyone who has looked at real estate prices in San Francisco or Manhattan recently might conclude that they could fall 30% without necessarily sparking a national catastrophe.

"Bill Gross is being melodramatic," Atteberry says. "Come on, let's, be honest -- subprime in, say, Omaha, Neb., is probably pretty small."

Atteberry also notes that Los Angeles real estate prices fell about 30% in the early 1990s, when the real estate bust was made worse locally because many defense contractors closed down. The local economy survived and recovered, he says.

And then comes the emotive issue: the bailout.

Gross argues the federal government should spend between $200 billion and $400 billion of taxpayers' money to "save" homeowners in trouble.

Atteberry's heterodox question: Why?

"We are not living in 18th century England," he says with exasperation. "These people aren't going to get thrown into debtors' prison." Instead, he points out, the homeowners who cannot meet mortgage payments will probably end up renting.

"They may even rent the same house they currently own," he says. The bank, after all, will need a tenant if it cannot find a buyer.

His second point: Many of those homeowners now in trouble are, almost by definition, those who have the least equity in their homes in the first place. They have big mortgages and high loans to value. So exactly whose "equity" are we really rescuing -- their's, or that of some billionaire hedge fund holding the paper?

And there is the issue of moral hazard -- the idea that unless people bear the consequences of behaving imprudently, they will continue to behave imprudently. "You have to ask yourself the question, why should the federal government bail out someone who made a bad decision as an adult?" asks Atteberry. "How do you cure excesses? The surest way I know to cure excesses is for the party to lose real money."

You could, frankly, go further. Many other forgotten people rented during the real estate bubble. They wisely shunned the hype and refused to take on too much debt to buy a home they couldn't afford.

Where are they now?

If politicians jump on Gross' proposal, these people would be forced to pay higher taxes in order to save other, less prudent people from the alleged indignity... of having to rent.

Some will be forced to subsidize their own landlords. Fair?

As for the risks to the financial system, Atteberry points out that the federal government, via Fannie Mae(FNM), Ginnie Mae and Freddie Mac(FRE), already guarantees huge mounds of mortgages.

Pimco could not be reached Friday for comment.

Many politicians, looking for a scapegoat, are pointing the finger for the housing bust at "predatory lenders." Atteberry notes that the law already criminalizes such behavior. Any lender or broker who misled a borrower committed fraud.

He adds, though, that there is a second group to look at. Predatory ... borrowers. Any borrower who lied on a mortgage application, by inflating his or salary, say, or covering up a "soft second" mortgage, is also guilty of fraud.

Will the politicians go after those people too?

Don't hold your breath.