Mohamed A. El-Erian is the co-ceo of the world's largest asset management company Pimco. An interview about the ins and outs of the credit crunch.
Mohamed El-Erian has worked through the weekend again, just like he has every other weekend over the past weeks. When the American government announced the comprehensive bail out plan for banks, he wrote a ten page investment instruction for his employees at Pimco, the largest asset manager in the world.
During an interview with El-Erian on the 49th floor of the Allianz Tower, with a view on Central Park, he looks exhausted. As Pimco’s co-ceo is responsible for Pimco’s 830 billion dollars in assets.
He says the American bailout plan is “a necessary step because the situation had to be stabilized”. But he doubts it will be sufficient. “My sense is you need to do more. We are going to look back and 700 billion will not be the final number.”
He tells how he and his people at Pimco saw the markets stumble.
"Last week the only market that still functioned was that of short term US treasuries. Suddenly the money market funds were contaminated. So something that was viewed as a very arcane Wall Street matter suddenly became a Main Street problem. Losses were imposed on the biggest money market fund, a 62 billion dollar fund. As people realized that they started pulling their money out. For the fund to get liquidity, it had to sell. But the market was dislocated. Had the authorities not acted on Friday, you would have had a very big run on the money market funds and on the banks. You would have had cascading gates where those investors would have been told: come back tomorrow, or next week, to get your money out.”
In a crisis, when one is infected anyone can get infected?
"In August last year I was trying to take a holiday, I was back in the office - at Harvard at the time - the first day, because we started sensing difficulties. I asked our people: where is our cash? And they answered by telling me how much cash we had. But that wasn’t the answer to my question. ’It is in money market funds, with the best counter parties on Wall Street', they said, after I asked again. I asked what was in the money market funds, but they didn’t know. I told them at the time: take the money out and put it in treasuries and then let’s see. That was the reaction you saw last week, multiplied a million times. That made people question the integrity of the money market segment.”
The authorities have been trying to calm down the markets for a year now. But they haven’t succeeded.
"After Lehman and AIG, the US authorities shifted from targeting institutions to targeting the system as a whole. The authorities moved from piece meal measures to a package deal. If you go back to remarks of officials you find the words 'comprehensive package' only to appear last week. Before that it was like fighting isolated fires. The next step is happening very quietly, but I think it will accelerate. We are moving from a domestic response to an international response. The ban on short selling in different countries is a first example of that.”
Did the authorities worsen the situation?
"I worked at the IMF for fifteen years, so I’ve seen crises. This is exactly what happened in the Asian crisis [in the 1990s]. The first reaction is either policymakers do not recognize the crisis, or they do not believe there is a crisis. The US is not used to crisis management, particularly in what is seen as the most sophisticated financial system in the world. There is not enough information about the crisis. And when the authorities do have information, they realize their instruments are blunt. That they are creating collateral damage. This let to rational paralysis. The central question is: how are we going to get this stabilized? Gordon Brown gave the answer this weekend: 'Three words. Whatever it takes.' And that will lead to overreaction.”
But do the authorities know what they are doing?
"They are not doing it according to some master plan. Nobody decided at the beginning of the year that investment banks would no longer exist, that they were going to nationalize Fanny and Freddy. Nobody decided that they were going to intervene in an insurance company [AIG]. But it all happened. There is a reason for this. The system was undertaking activities that the infrastructure on the policy side and on the market side could not support. The amount of activities taking place in global finance far exceeded the capability of the system. I use the metaphor of the plumbing system where you are forcing very strong new flows into a plumbing system that is too old. So it is going to blow up and then you have to clean it up. And it is not going to be nice.”
What needs to be done?
"The authorities have tried to take three steps. The first is to reliquify the system, to get things flowing again, I suspect they have to cut interest rates in a globally coordinated fashion in order to make that happen. The second is this indiscriminate selling of assets. So they provided a balance sheet which is up to 700 billion to buy assets. I suspect they have to put capital directly into some of the institutions. The third step, which is causing the biggest anxiety in the markets, is a regulatory response. It is to try and enforce circuit breakers to the system. One of course is the banning of short selling. It was necessary, but not elegant.”
Regulators did not see this crisis coming?
"The blame game has yet to begin. The government, the regulators, the credit raters, the private sector, they were all at fault at some point. The central question will be: who lost the American financial system? If you want hear a big mistake that was made on the government side, look at the off balance activities, the conduits and the SIVs [structured investment vehicles], that were completely unregulated. There were no capital requirements. Those activities were the first to go down in the crisis. And they contaminated everything else.”
Will this crisis be a turning point for regulators?
"We are going to overreact on the regulatory part now. When this is all finished, we are going to end up with a much smaller, slimmer and less risky financial system. The good news is that the likelihood of a future crisis can be reduced. The bad news is that we are going to lower the speed limit for the growth of the economy. That is a cold shower for people in this country.
"A very well-paid industry, which is what finance is, was living in a system that privatized the gains and socialized the losses. Society will not accept that. Keep in mind, the 700 billion is more than the whole social service budget of the United States."
Who, after the investment banks, are going to be the next victims?
"The fall of the investment banks was inevitable after the Fed opened up the liquidity window, with the rescue of Bear Stearns. That dissolved the difference between commercial banks and investment banks. It was only a matter of time before the other investment banks would disappear, either through bankruptcy, acquisition or a change in their business model. The next businesses under pressure are the hedge funds.
"The keyword here is leverage. Investment banks used a leverage over 30. On every dollar they owned, they borrowed over 30 to invest. When the market goes up, the profits are enormous, but the losses are as big when markets come down. The market for investing with borrowed money has dried up completely. Hedge funds work the same way, with a little less leverage.
"Further down the line you have the non-financial institutions, the AIGs of this world,. And the commercial banks, which have a 10 to 1 leverage. And there is us, without any leverage. Last year everyone said we were boring. We avoided risks, so we didn’t have high returns. But now the fact that we’re not levered is really important.”
Is this the end for leverage?
"No, the system cannot handle that. If you deleverage too quickly, you’ll shock the real economy. The 700 billion help deleverage investment banks and investors. I think the line will be drawn at the commercial banks. They invest every dollar they have ten times, but that is an acceptable risk.”
After the 1929 Great Depression it was decided to separate commercial banks and investment banks. Clinton changed that. What will happen next?
"Creative destruction is part of capitalism. Capitalism destroys parts of itself and recreates itself stronger. By its very nature has a tendency to run ahead of what the system can accommodate. But it is very significant when this happens in the financial system, because that ties everything together. We will go through this cycle again every 30 or 40 years.
"Politicians will have to make the decisions. Do we want a Wild West financial system? One that innovates, produces many things, allows homeownership to go up - which is good for society, but that will fall down once in a while. Or do we want a very regulated system? One that is safer, but doesn’t allow all these innovations. The economist [Hyman P.] Minsky wrote: stability leads to instability in a capitalistic system. And instability leads to stability.
How do you see the role of the sovereign wealth funds. They can offer the liquidity the West needs. Do you feel SWFs can balance the system?
"SWFs have what is most needed right now, and that is pure capital. They are long term investors. The bulk of them are only interested in ownership, not control. They stepped up in the last quarter of 2007 and put 60 billion dollars of pure capital in the western financial system. And they got criticized for it. Now they are sitting on losses.
"They are on the sidelines, watching the game. They don’t quite understand the rules anymore, nobody does. They won’t get involved again until the air clears. They will be part of the solution, but they are not going to be the leaders of the solution, they are going to be reactive. The speed with which the original credit crunch has changed into a global confidence crisis was unthinkable. But all the unthinkable has become thinkable in the last few months.”
What is the main characteristic of this crisis?
"The main characteristic is what you don’t see. It is happening behind the scenes: the confidence crisis between banks, the end of the market for loans, the disappearance of liquidity."
Did central banks created too much liquidity, did they over-fuel the system?
"I think that is unfair. Greenspan [Former Fed chairman] first, and after him Bernanke raised interest rates from 1 percent to 5.25. As they were raising short term interest rates, long term interest rates where coming down. This is one of the many signals that the system was sending out. But the marketplace said: these are not signals, this is noise. The market tried to tell us something and no one listened.”.
How big will the damage be?
"Let me leave you with a thought that scares me the most. So far the world is deleveraging three balance sheets. First that of US housing, which peaked in the summer of 2006. Secondly the financial sector, which peaked in the summer of 2007. The third one , which peaked this summer and now starts to deleverage, is the US consumer. The good news about all of these three things is there is a stock of wealth underneath them, to dampen the consequences.
"But there is one balance sheet out there that so far has avoided all this, but is now coming under pressure. That is the growth in emerging markets. It is slowing down. If that balance sheet is forced in contraction, the welfare implications are huge. Because those markets do not have a wealth cushion. It will mean poverty, much more pain, and much more human suffering. That’s my major concern: if this doesn’t get stopped and the tidal wave is going to hit people that are least able to survive it."
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