Want to solve the current credit crisis? Solve for housing, according to PIMCO‘s Bill Gross, in his latest investment outlook for August. But it’s an equation that’s proving to be maddeningly difficult to balance, even for fund managers with returns to deliver unto investors. “One of the wisest men I know has this serious but admittedly impractical solution: have the government buy one million new/unoccupied homes, blow them up, and then start all over again,” Gross writes. “Absent that, he’s not quite sure what to do, nor am I.” In other words, HW readers, we’re facing a housing cycle that in the short run isn’t likely to solve itself. Which means it’s time to strap in. Gross suggests that the housing legislation now making its way through Congress may be of some help, at least in the form of making sure that the primary sources of mortgage liquidity, Fannie Mae (FNM) and Freddie Mac (FRE), don’t blow up in the near-term. “[L]owering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy,” he suggests, although it’s clear from his remarks that even Gross doesn’t believe it’s a great way to get there. But our options are somewhat limited by a cost of credit that seems stubbornly set on rising further amid growing fears over inflation. “The cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability,” Gross said. Which means that homes are in for a rough ride, something that the investment side of the mortgage business is now coming to grasp. Fitch Ratings, for example, suggested Thursday afternoon that home prices nationwide may fall 25 percent or more in real terms over the next 5 years. For his part, Gross now sees a trillion dollar loss looming — numbers that line up with the estimates we’ve been privy to at HW from a few of the large hedge funds lining up to invest in distressed mortgage debt and bonds. “PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble,” according to Gross. “The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a ‘negative feedback loop.'” That negative feedback loop? I think the real fear should be reserved for what happens once we’re in the looping cycle; because getting there strikes me as a foregone conclusion at this point. And I’d expect Treasury secretary Henry Paulson is more than aware of the same; which is why he’s ditching every free-market, Wall Street-trained tendon in his body to push for what is essentially an unlimited federal lifeline for the GSEs.

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