July 21 (Bloomberg) -- Bill Gross, who manages the world's biggest bond fund, said it's not possible for government sponsored mortgage-finance companies Fannie Mae and Freddie Mac to raise capital without the Treasury Department's support.

``Let's be blunt: to the extent the Treasury suggests they'll never have to use their authority, that's a sham,'' said Gross of Pacific Investment Management Co. ``It's fallacious to suggest that the agencies could issue capital, preferred stock, without the co-participation of the Treasury. I don't think that's possible.''

Freddie Mac said on July 18 that it intends to proceed with a $5.5 billion capital-raising plan it announced in May that will include both common and preferred securities. Pimco wouldn't buy the companies' stock without the Treasury's involvement, Gross said, in a Bloomberg Television interview from the firm's headquarters in Newport Beach, California.

Treasury Secretary Henry Paulson is pushing Congress to authorize the Treasury to purchase equity stakes in Fannie Mae and Freddie Mac and expand government-backed credit lines to them amid concern that they don't have enough capital to weather the worst housing slump since the Great Depression. Freddie Mac shares have tumbled 74 percent this year and Fannie Mae has dropped 65 percent. The companies make money by guaranteeing mortgage-backed securities they create out of loans bought from lenders and sell to investors worldwide.

Mortgage-backed bonds issued by Fannie Mae and Freddie Mac are ``an excellent buy'' compared with debt of the agencies, Gross said.

Total Return Fund

``It's basically the mortgages where many buyers have stood aside,'' including sovereign wealth funds and central banks, said Gross, 64. ``Not only do you have the agency guarantee, but you have the mortgage to back you.''

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.

Cash equivalents, a category of assets with duration of less than one year, made up the second-largest portion of the fund. Duration reflects the sensitivity of a bond's price to changes in interest rates.

Pimco also considers the debt of ``high-quality banks'' such as JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. ``very attractive'' at current yields, Gross said.

`Wrong Approach'

Housing prices will fall another 10 percent to 15 percent over the next 12 months, making it a mistake for policy makers to raise borrowing costs to curb inflation, Gross said. 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.

``To suggest that the Fed or a central bank should raise interest rates in the face of a significant asset deflation, a significant housing deflation, is certainly the wrong approach, to put it mildly,'' Gross said. An increase in the target rate for overnight lending between banks amid rising unemployment ``would be tantamount to raising interest rates in the mid- 1930s,'' he said. The U.S. economy during that decade was in the midst of the Great Depression, the worst economic contraction in its history.

Traders see a 77 percent chance policy makers will raise borrowing costs by at least a quarter-percentage point by the end of this year, according to interest-rate futures traded on the Chicago Board of Trade.

U.S. consumer prices climbed 5 percent in the 12 months through June, while the unemployment rate held at 5.5 percent, the highest since 2004.

Treasuries `Overvalued'

The U.S. dollar will continue to fall against currencies of emerging-market countries, Gross said. The dollar will also weaken as the U.S. federal budget deficit, which widened to $163 billion last year, swells to as much as $1 trillion and leads to larger sales of U.S. government debt, he said.

``Three years hence, we will see a trillion-dollar deficit to support the U.S. economy,'' Gross said. ``That's a lot of paper, and that's a lot of compression downward of the value of the U.S. dollar against most other currencies.''

The dollar has fallen against nine of the most actively traded emerging-market currencies this year, and has registered declines of more than 20 percent against the Czech koruna, Polish zloty, Hungarian forint and Slovakian koruna.

U.S. Treasuries including Treasury Inflation Protected Securities, or TIPS, remain ``overvalued'' relative to assts like mortgages and corporate bonds, Gross said.

Gross's Total Return fund has returned 4.7 percent annually over the past five years, beating 84 percent of its peers in the government and corporate bond fund category as of July 18, according to Bloomberg data. The fund held no Treasuries as of June 30, according to the firm'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; Kathleen Hays in New York at Khays4@bloomberg.net.

Last Updated: July 21, 2008 16:32 EDT