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Bill Gross: The End of the Wild West

"Government fist" will quash version of capitalism of the past 15 years, PIMCO manager says.

Eric Jacobson, 10/16/2008

In a market like this, with events unfolding so fast that the morning news can easily grow stale by noon, the thoughts of market experts don't remain salient for long. Fortunately, the conversations we've had over the past couple of weeks with PIMCO co-chief investment officer Bill Gross--who manages the firm's flagship PIMCO Total Return PTTRX--have remained relevant through the turmoil and have even proven prescient.

Gross was encouraged that the passage of the U.S. Treasury Department's $700 billion Troubled Asset Relief Program (TARP) would pay off in a few ways. In particular, he was confident that the acquisition of troubled mortgages by the U.S. government would ultimately produce profits for Uncle Sam. As long as the government picks them up at the right price--and there's a lot of room for error given how cheaply subprime mortgages are currently being marked--returns of 10% or more are well within the range of possibility, according to his analysis.

But the main reason for his advocacy of the plan was that he believed that government inaction would have had catastrophic outcomes, including massive job losses, plummeting economic productivity, and waves of bankruptcies. In fact, in the absence of an effective government policy response, Gross had described a "daisy chain" of trouble snowballing from margin calls, disappearing leverage, and institutional failures that would roll through the financial, housing, commercial real-estate, stock and bond markets. Meanwhile, he also saw the TARP as a catalyst that would put banks in a better position to make loans.

A Seemingly Far-Fetched Idea Become Policy
Gross hadn't been overly sanguine about the next phase, though, noting several days ago that putting banks on a better footing wouldn't be the same as truly fostering the conditions under which they might get back to providing the U.S. economic system with the lending capacity it needs. In fact, he made very clear more than two weeks ago what he really wanted to see: the Treasury injecting capital directly into the nation's banks in exchange for preferred stock.

That seemed unlikely at the time, given Treasury Secretary Henry Paulson's desire to avoid getting the public sector overly involved in the banking system, a measure he was concerned would result in "picking the winners and losers." But on the heels of action by others, including the U.K. and Euro zone governments, the U.S. Treasury came around and announced such a plan on Oct. 14, declaring its intent to inject $250 billion into the banking industry over the next several weeks.

Gross said that without that kind of cash injection, many banks wouldn't have the capital base necessary to produce the volume of loans required to resume a more "normal" state of lending, credit, and capitalism. That and steps to "reliquify" the market for short-term commercial paper (a task whose administration has been assigned to PIMCO), guarantee money markets, hike the limits on FDIC bank account protections, and to federally guarantee new bank debt all appear to have given the broader markets a boost of confidence.PAGEBREAK

Can We Really Afford All of This?
With the specter of such massive government spending on the horizon, though, we pressed Gross for his thoughts on the future. Neither he nor his colleagues at PIMCO seem too preoccupied with inflation at this moment, given the obvious need to stabilize the markets first and foremost. Gross, however, says that there were foreign central banks and non-U.S. investors leery of this country's growing Treasury issuance (though it will be interesting to see how loud that sentiment remains now that Europe and the U.K. are stepping in with their own spending actions). He also believes that it won't be until two to three years from now until we really begin to see the effects of that activity. Gross cautions to remember the post-World War II economy, when broad U.S. government price controls were eliminated and a burst of mid-1940s double-digit inflation ensued.

The U.S. has been living on the creation of more and more debt for some time, activity that can cheapen the value of our currency versus those of more fiscally restrained nations, Gross says. Unless something changes, he argues that we can't expect the U.S. dollar to maintain long-term strength, a point that he and PIMCO have been making for many years.

There's a New World Order
Perhaps the most difficult issue to really grasp at this stage is that of change to our overall capitalistic system and ethic. Gross believes that the system will no longer be able to operate as it has for the past 10 to 15 years. We're in store for more regulation, a smaller universe of bank lenders who will dominate financial business, and less reliance on Adam Smith's "invisible hand," which has long been viewed as promoting the interests of both individuals and the broader economic community.

By contrast to the Smith ethos, Gross invokes colleague Paul McCulley's prediction that we will be under the domination of a "government fist" when it comes to financial market control. The Wild West, Gross says, is taking the train back to the East Coast.

Eric Jacobson is a fixed-income specialist with Morningstar. 

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