July 24 (Bloomberg) -- Falling U.S. home prices will force financial firms to write down $1 trillion from their balance sheets, crimping bank lending and sparking sales of assets, said Bill Gross, who manages the world's biggest bond fund.

A total of $5 trillion of mortgage loans, or almost half of the nation's home loans, belong to ``risky asset categories'' such as subprime and Alt-A, Gross of Pacific Investment Management Co. said in commentary posted on the firm's Web site today. About 25 million U.S. homes are at risk of negative equity, which could lead to more foreclosures and a further drop in prices, he said. A home has negative equity when it's worth less than the mortgage with which it was bought.

``The problem with writing off $1 trillion 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,'' Gross wrote.

The U.S. House of Representatives approved yesterday a bill designed to shore up confidence in mortgage-finance companies Fannie Mae and Freddie Mac and stem mortgage foreclosures. Treasury Secretary Henry Paulson earlier this month proposed allowing the government to purchase equity stakes in the companies and expanding their credit lines. The proposals followed speculation that the companies, which own or guarantee almost half of the $12 trillion of outstanding home loans, didn't have enough capital.

`Blow Them Up'

While Congress will enact the bill into law, lawmakers won't give the Treasury Department unlimited authority to buy Fannie Mae and Freddie Mac's debt or equity, Paul McCulley, a fund manager at Pimco, said in a separate commentary. Instead, lawmakers will probably count any government funds that go toward the companies against the Treasury's legal borrowing limit, which is controlled by Congress, he said.

The government could boost housing prices by buying one million new or unoccupied homes, ``blow them up, and then start all over again,'' Gross wrote, adding that the suggestion comes from ``one of the wisest men I know.'' Aside from that solution, the housing legislation ``is the best way to begin the long journey back to normalcy,'' he said.

Gross's forecast implies that credit-market losses are less than halfway over. Since the start of 2007, firms including Citigroup Inc., Merrill Lynch & Co., and UBS AG have reported $467.9 billion in losses and writedowns after the collapse of the U.S. submprime mortgage market roiled credit markets, according to data compiled by Bloomberg News. Firms worldwide have raised $344.2 billion of capital since the third quarter of 2007.

Record Drop

Former World Bank President James Wolfensohn and Charles R. Morris, the author of ``The Trillion Dollar Meltdown,'' are among those who share Gross's estimate. Wolfensohn said April 28 that losses from the global credit turmoil may climb to $1 trillion. The International Monetary Fund predicted $945 billion of losses on April 8.

Home prices in 20 cities dropped 15.3 percent in April from a year earlier, according to S&P/Case-Shiller, the most since the group began collecting data.

The U.S. central bank's seven cuts in the benchmark lending rate since September haven't led mortgage rates to fall or slowed the decline in home prices, Gross said. Rather, yields on 30-year mortgages have risen in that period.

Policy makers have reduced the target rate for overnight lending to 2 percent from 5.25 percent in that period, pursuing the most aggressive series of cuts since the 1980s.

Fed Cuts

The average rate on a typical 30-year fixed-rate mortgage has risen to 6.51 percent, from 6.10 percent at the start of last September, according to data from Bankrate.com.

Falling bank stocks may make it difficult for firms to raise more capital, Gross said in a Bloomberg Radio interview. The Standard & Poor's 500 Financials Index has declined 28 percent this year. Banks may take up to two more years to report a total of $1 trillion in writedowns, he estimated.

The government's rescue package probably won't be enough to revive the housing market because Fannie Mae and Freddie Mac have ``signified they're in a balance sheet reduction mode,'' Gross said in the interview. The companies ``have to be willing to take some chances of their own to buy mortgages.''

The cost of the government rescue package to taxpayers ``will run into the trillions,'' Gross added. ``I'm forecasting three years from now we'll see our first trillion-dollar budget.''

Eight of the top 10 holdings in Gross's $128.8 billion Total Return Fund were mortgage-backed securities guaranteed by Fannie Mae, according to data compiled by Bloomberg News as of March 31, the latest date for which figures are available. Mortgage securities made up 61 percent of the fund as of June 30, up from 53 percent a year earlier, according to Pimco's Web site.

Pimco, a unit of Munich-based Allianz SE, has $830 billion of assets under management.

To contact the reporters on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net;

Last Updated: July 24, 2008 15:48 EDT