Credit markets face another $250 billion in defaults over the next two years, indicating that the worst of the subprime crisis is yet to come, the head of the world's biggest bond fund told CNBC on Monday.
"We've only begun to see the pain from the standpoint of the homeowner in terms of those monthly payments," said Bill Gross, chief investment officer of Pacific Investment Management or Pimco. "Defaults and delinquencies will increase as we extend throughout 2007 and into 2008."
Gross blamed "garbage loans" issued by large banks who couldn't guarantee them and consumers who couldn't afford them. Large lenders like Citigroup , Merrill Lynch and Bear Stearns will be paying the price, he said.
Gross's comments came the same day that JP Morgan said total losses stemming from writing down the value of mortgage-linked securities could be as high as $200 billion, with financial institutions sitting on at least $60 billion in losses that have not yet been disclosed.
Citi on Monday said its exposure to subprime writedowns increased to as much as $11 billion and could grow if the market deteriorates further. Merrill recently revised its figures regarding subprime writedowns, saying it would sustain an $8.4 billion hit.
The turmoil in the subprime mortgage-market is a "$1 trillion problem ... there are $1 trillion worth of subprimes and Alt-As and basically garbage loans," Gross said.
The problems in the mortgage market stem from subprime and Alt-A loans with adjustable rates that are suddenly resetting upwards, said Gross.
"The overall problem is one in which the mortgage industry and homeowners themselves took the bait to the tune of 10 to 15 percent higher prices than they should have been paying, and ultimately that (harms) the economy as a whole," Gross said.
The Fed will need to continue to cut rates substantially to ward off further mortgage defaults and the continuing issues plaguing the banking industry, he added.
Gross said the Fed must cut its federal funds target rate enough to get 30-year mortgage interest to about 5 percent.
"The Fed is in a corner here," he said. "They do have to fight inflation but they do have to fight asset deflation in terms of housing."
The housing market is facing turmoil in so-called subprime loans made to borrowers with shaky credit.
Delinquencies are rising on subprime mortgages and defaults are piling up at record rates as home prices sink, pressuring consumers' desire to spend.
Gross expects the Fed to move aggressively into the new year. "Ultimately, the Fed has moved down to what we measure as a 1 percent -- or lower -- real interest rate in order to support the economy and revive it again," he said. "A 1 percent real interest rate when tacked on to a 2.0-2.5 percent inflation rate is really a 3.5 percent short-term rate. Ultimately, that's at least where they are headed."
Gross said a 3.5 percent fed-funds target rate implies that the 30-year mortgage rate comes down to 5.0-5.5 percent. "We haven't seen that yet - and that is part of the problem," Gross added.
The problems don't stop there, however.
Municipal-bond investors, he said, must make sure that the underlying foundation of their bonds are solid. "There's not a problem with solvency or default here, but there's a problem in terms of ratings," he said. "These monoline insurers that rate municipal bonds that take a single A or Baa bond to triple-A based on the insurance ... if the insurance companies are written down, then no longer do we have triple-A or double-A munis."