<strong><a href="http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2007/IO+July+2007.htm?ref=patrick.net">Looking for Contagion in All the Wrong Places</a>
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<p align="justify" class="Noparagraphstyle" style="margin: 0in 0in 0pt;"><strong style="">The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes – the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond.</strong> If delinquencies lead to defaults and then to lower home prices, then we have problems and the potential for an extended – not a 27-day Paris Hilton sentence. Take a look at Chart 1, which graphically points out the deterioration in subprime ARM delinquencies.
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<p align="center" class="Noparagraphstyle" style="margin: 0in 0in 0pt;"><img border="0" alt="" src="http://www.pimco.com/NR/rdonlyres/D1F01FBD-786F-4CF7-811C-EBCDB7B6CCE1/4184/chart1.gif" /></p>
<p align="justify" class="Noparagraphstyle" style="margin: 0in 0in 0pt;">Escalating delinquencies of course ultimately lead to escalating defaults. Currently 7% of subprime loans are in default. The percentage will grow and grow like a weed in your backyard tomato patch. Now I, the curmudgeon of credit, am as sure of this as I am that the sun will set in the west. The uncertain part is by how much. But look at it this way: using the current default rate of 7% (3-4% total losses), the holders of some BBB investment grade subprime-based CDOs will lose all of their moolah because of the significant leverage. No need to worry about fictitious 100 cents on the dollar marks here. One hundred percent of nothing equals nothing. If subprime total losses hit 10% then even some single-A tranches face the grim reaper. AAA’s? Folks the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the <u style="">timing</u> of the unwind. 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 <em style="">The New York Times</em>. And it will not remain confined to a neat little Petri dish in some mad financial derivative scientist’s laboratory. Ultimately through capital market arbitrage it will affect risk spreads in markets completely divorced from U.S. housing. What has the Brazilian Real to do with U.S. subprimes? Nothing except many of the same bets are held in hedge funds that by prudence or necessity will reduce their risk budgets to stay afloat. And the U.S. economy? Of course it will be affected. Consumption will be reduced to say nothing of new home construction over the next 12-18 months. After all, attractive subprime pricing has been key to the housing market’s success in recent years. Now that has disappeared. <strong style="">Importantly, as well, and this point is neglected by most pundits, 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</strong>.</p>
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<p align="justify" class="Noparagraphstyle" style="margin: 0in 0in 0pt;"><strong style="">If not taken too far – and there is no hint yet of a true “crisis” – these developments may be just what the Fed has been looking for: easy credit becoming less easy; excessive liquidity returning to more rational levels</strong>. Still, PIMCO looks for the Fed to issue an insurance policy in the form of lower Fed Funds at some point over the next 6 months. And what happened to our glass half-full secular thesis of last month? We still believe in strong global growth, but…as we also suggested…that the U.S. housing downturn will affect growth <u style="">and</u> short-term yields over the next year or so. We remain consistent and resolute. Contagion? Maybe, but you won’t be finding it at “99.9%” pure Bear Stearns. Look for it instead, in the subprimely financed homes of Las Vegas, Rockford, Illinois, and Miami, Florida. This problem – aided and abetted by Wall Street – ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address – Main Street. </p>
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<p class="Noparagraphstyle" style="margin: 0in 0in 0pt;">William H. Gross</p>
<p class="Noparagraphstyle" style="margin: 0in 0in 0pt;">Managing Director</p>
