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September 03, 2007 01:00 AM

Subprime bailout would be bad news, Arnott says

Jay Cooper
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    PASADENA, Calif. — If Congress bails out troubled subprime mortgages, it’s the economy that will suffer, Research Affiliates Chairman Rob Arnott said.

    If Congress doesn’t act to save borrowers and lenders who created the subprime fallout, there will only be a minor slowdown with a one or two percentage point reduction in gross domestic product, Mr. Arnott said.

    But if Congress decides to step in — either by taxing others or borrowing money to fund the bailout — it will create a major recession, said Mr. Arnott, an avowed libertarian. He estimates that bailout could cost as much as $500 billion.

    Mr. Arnott is betting on the latter scenario. “There’s a little too much sympathy for people who bought the homes they wanted even though they knew they couldn’t afford it, and now they can’t afford them,” he said.

    Resisting a bailout would teach lenders and borrowers not to take excessive risk. Sometimes, that lesson needs to be taught, Mr. Arnott said. Funding a bailout will create inflationary risks and will exacerbate any recession.

    “If they do (fund a bailout) all they’re doing is taking borrowers who should never have borrowed, lenders who should never have lent and rewarding them for foolishness.”

    Mr. Arnott is the subadviser for the PIMCO All-Asset Fund, a $12.5 billion mutual fund of funds that invests in other mutual funds of Pacific Investment Management Co. LLC, Newport Beach, Calif. He is responsible for asset allocation decisions for the fund, and has adjusted the portfolio in anticipation of Congress bailing out the lenders and borrowers.

    The inflationary pressures caused by the bailout would harm the typical pension fund’s60/40 equity and bond portfolio. Mr. Arnott has moved the PIMCO fund away from that allocation. He would not discuss changes made in the third quarter but said “we have been underweight in U.S. equities.” The fund has been overweight in inflation-linked bonds, short maturity duration debt with low volatility and emerging market debt, especially debt denominated in a local emerging market currency. 

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