Investors fooled by triple A ‘hooker heels’ says Pimco’s Gross

In his July Investment outlook, Pimco managing director Bill Gross describes the problems surrounding Bear Stearns’ hedge funds as a “Paris Hilton charade of a crisis” and says that those that point to a crisis averted and a return to normalcy are really looking for contagion in all the wrong places.

The problem, he writes, lies not in a Bear Stearns hedge fund that can be papered over with 100-cents-on-the-dollar marks, but in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006.

He points out that at the current default rate of 7% (3-4% total losses), the holders of some triple B investment grade subprime-based CDOs will lose all of their money. If subprime total losses hit 10% then even some single-A tranches face the grim reaper. The rating agencies, he says, were fooled by the makeup and six-inch hooker heels [of these asset-backed securities].

Attractive subprime pricing has been key to the housing market’s success in recent years, he concludes. Now that has disappeared, the willingness to extend credit in other areas – high yield, bank loans, and even certain segments of the triple A asset-backed commercial paper market should feel the cooling Arctic winds of a liquidity constriction.

Fishknife comments:

It has taken less than 24 hours for Bill Gross’s “six-inch hooker heels” jibe to pass into folklore. You can be sure that critics will be using the phrase to attack the rating agencies for decades to come.

Hats off to the master polemicist. But is he right? His precise allegation is that the triple A securities are tarted up. But he makes a convincing case only for defaults at the single-A level. That slightly undermines his argument. But he is of course correct to say that mark-to-market losses for triple As could spook the wider market.

Gross has long been suspicious of CDOs and derivatives which, as one CDO manager points out, is ironic given that Pimco is also a big manager of these deals, including Costa Bella CDO 2006-1, a mezzanine ABS CDO launched at the end of last year which must surely now be feeling the pinch.

Pimco’s phenomenal success as an asset manager is to a large extent the result of Gross’s reputation as a macroeconomic visionary. So these comments will do nothing to harm its CDO business. Still, it is bound to lead to some embarrassing questions from potential investors on Pimco’s next CDO roadshow.