Financial System Stability

OPERATOR: Excuse me, everyone; we now have your speakers in conference. Please be aware that each of your lines is in a listen-only mode. At the conclusion of today's presentation we will open the floor for questions. At that time instructions will be given as to the procedure to follow if you would like to ask a question. And now let's turn the conference over to Michael Wiseman.

Mr. Wiseman, you may begin.

MR. WISEMAN: Thank you very much. Welcome to the Council on Foreign Relations call on "Financial System Stability." I'm Michael Wiseman of Sullivan & Cromwell. This call has about 150 participants and is going to be on the record.

It's a great pleasure to have as our speaker this morning Mohamed El-Erian, co-CEO of PIMCO. After his academic training at Cambridge and Oxford, he served with distinction at the IMF. Since then he has had a remarkable career in the financial services sector at Salomon Smith Barney, Harvard and PIMCO. His performance at Harvard is particularly gratifying to those of us who have contributed to the capital he was investing.

In his recent book, "When Markets Collide," he drew on his broad experience not only to analyze fundamental shifts in the global economy but also to discuss the current economic crisis in the context of those shifts. His book, although very recently published, ended with Bear Stearns. In the short time since then, we have seen Freddie, Fannie, Lehman, AIG, the seizing up of the debt market, the end of the SEC's consolidated supervision initiative, the transformation of leading investment banking firms into bank holding companies, and the passage of emergency legislation.

To start off today's discussion, in addition to whatever other opening remarks he would like to make, I would ask our speaker to tell us what he draws from all of that and in particular whether it changes his thinking on the course we are on and the obstacles to reaching our destination.

Mohamed?

MR. EL-ERIAN: Thank you, Michael. And thank you, everybody, for calling in. And a big thank you to colleagues at the council for inviting me.

Let me start with where Michael suggested, which is the message of the book was a very simple one. It suggested that the system was undertaking activities that far exceeded the system's ability to sustain them and therefore it was inevitable that we would have a series of market accidents and policy mistakes. And the question was the extent of the disruption and the reality that, to put it as the phrase that has been picked up a lot, the unthinkable becomes thinkable in a world that can no longer sustain the activities taking place.

And what we have seen since then is an acceleration of both policy mistakes and market failures. I was talking with the organizers while we were all waiting for the call to begin that the choice of password "stable" was an interesting one because stability is what is very elusive right now for the system. And because of that, the crisis is morphing and will continue to morph in terms of its reach, in terms of its consequences, and in terms of its duration.

The best way of thinking of where we are and, importantly, where we're going to go is to use a very simplified framework that we have been using at PIMCO for months now and that has served us really well, and think in terms of a tug of war or a race. On the one hand you have the de-leveraging dynamics, the need for different sectors -- and there are at least sectors right now: housing, finance and the consumer -- the need for each sector to trim, reduce their balance sheets. That is a very disruptive process. It's basically shouting "fire" in a crowded theater and having a small door for everybody to rush through. So the de-leveraging dynamics, left to their own devices, get worse until the process exhausts itself, and the process exhausts itself after a very long period of destruction. That's one element, if you like, in the tug of war or in the race.

Against that you have the stabilizers, and they take the form of fresh capital, fresh balance sheets that are able to absorb the assets and the businesses that need to be sold, and the policy circuit breaker, the ability of policymakers to break the process.

As long as the de-leveraging dominates, which has been the case for the last year-plus, then the process continues to morph. It becomes very volatile, it becomes unpredictable, and virtually any segment is prone to contamination.

And the last few weeks I think have served as a massive wakeup call to anybody who doubted that this is what we're talking about. Talk of isolated damage has correctly given way to a realization of four important things.

First, it's not about the banks anymore, but it's about the banks and other non‑bank financial institutions. So companies like GE have to raise capital. The insurance companies come under pressure. And it is spreading.

Second, it's not about the U.S. It's global. And the events that happened over the weekend have really made Europe in particular realize that their problem may be as large as the U.S.

Third, it's not just levered institutions. It's not just hedge funds. But even unlevered institutions are threatened and the problem with the money market funds a couple of weeks ago was a very important illustration of that.

And fourth and most important, it's about the pipes. It's about the payments and settlement system. It's about the trust that any financial system takes for granted, and that trust is no longer there.

It is no surprise therefore that this disruption has migrated from Wall Street to Main Street and will continue to do so. Our expectation is that you're going to see a very dramatic decline in virtually all indicators of economic activity because of what's going on right here.

What about the next step of the crisis? Remember the tug of war. Left to its own devices, the de-leveraging gets worse before it gets better. It contaminates more and more sectors.

In a world like that, new capital, including sovereign wealth funds, who had stepped up to the plate, become very reticent. They stand on the sideline like any cautious investor would do until they get clarity. To use a phrase that is often used, this is not the time to worry about the return on your capital. This is the time to worry about the return of your capital. And if you have capital, you wait and see how things are going to work out.

So critically, as to where we go here is not whether the endogenous circuit breaker, new capital, is going to work. It will not. It's whether policy can overcome market failures. And here we're starting to see the change.

I mentioned earlier that the book suggested that in the world we're living in today it is inevitable that we're going to get market accidents and it's inevitable that we're going to get policy mistakes. It is not that the policymakers don't get it. It is they don't have sufficient data and, critically, they don't have the right instrument. The policy infrastructure, just like the market infrastructure, needs to catch up.

So it's not surprising that the initial policy response, which has been dramatic in terms of actions but less dramatic in terms of consequences, hasn't worked completely in breaking the de-leveraging. Just think, you know, the bold policy actions we've had -- a bipartisan fiscal stimulus package, the Fed taking $29 billion from Bear Stearns on its balance sheet, the Fed intervening with AIG to the tune of $85 billion, $200 billion of capital being made available to Freddie and Fannie, $700 billion in terms of the top. These are all dramatic policy actions, and yet they haven't broken the dynamics.

And what we are looking for is for the policy reaction to go from being sequential to be -- set of national policy responses to being some coordinated policy response and for it to impact at the same time what we think are the four critical areas: the pipes of the system, the payments and settlement; short-term funding, et cetera, the capital of the system, the removal of the overhang of bad assets, and the regulatory side.

Let me conclude my initial remarks by a much broader comment that I think is of consequence to everybody on this call.

The financial system is like the oil in a car. You don't think about it very much, but if it stops working then it impacts everything else. One consequence of what we're going through today is that the financial landscape is being redefined. Institutions are disappearing. Regulations are changing. Market behavior is changing. And this is not being done according to some master plan; it is being done inevitably in reaction to a series of crises.

So this is crisis management where new facts are being created on the ground, which means that once we emerge from all this it will be with a very different landscape and it will be with one that it is not yet consistent because all these different facts are being created sequentially. Therefore, whoever touches the financial sector is going to have to look at the way they interact with the financial sector, because if the financial sector landscape changes, then these relationships would also change.

Let me end here, Michael. I am happy to answer whatever questions you or others may have.

MR. WISEMAN: Well, let me start off with a couple and then turn it over to the broader audience. But a lot of financial institution regulation and the approach in the last couple of decades has focused on the need for moral discipline and the dangers of the moral hazard if the government intervened to protect institutions. After intervening in Bear Stearns, perhaps there was a great impetus to draw the line somewhere, and the line was drawn at Lehman Brothers, which perhaps could be viewed as a turning point or at least a precipitating factor in what's happened.

I guess at least in the near term what do you view as the -- and given the imperfect information everyone has to deal with in making judgments and their reliance in the markets on public confidence, what do you think is the role now or the balance that can be struck now between market discipline and moral hazard?

MR. EL-ERIAN: Having worked at the IMF for 15 years, I have a lot of sympathy for those that were -- (inaudible) -- moral hazard, and I worry about it even at home. (Laughs.) Moral hazard is a real concern.

There are times when a fire is started in a neighborhood by someone who should not be saved, but because of the way the wind is blowing this fire starts impacting hundreds of home that are occupied by innocent bystanders. So I think the moral hazard issue today is important but should not be the defining issue. The defining issue should be how to we get out of a system that privatizes the gains and socializes the losses.

And once we come out of this crisis, there's going to be a lot of discussions about what I call claw-backs, which is the ability of the system to claw back compensations. And some of the companies already have that in place to ensure long-term focus in terms of institutions rather than short-term focus. We're going to be talking a lot about oversight and supervision to ensure that activities do not migrate as they did to areas that basically are under the jurisdictions of no regulators at all.

So there is going to be a need, an urgent need, for looking at the way regulation and supervision has been organized, including in the U.S. coordinating regulation supervision. But in the short term, as unpleasant as it sounds, okay, the urgency is to safeguard the system.

MR. WISEMAN: And one of your -- in your remarks you noted that this fire has now started to embroil Europe where, with the exception of Northern Rock for initial phases, they seem to be actually a bystander. Maybe -- could you comment a little bit more on that and maybe talk about how you see the contagion with respect to the rest of the world beyond U.S. and Europe?

MR. EL-ERIAN: Sure. You know, initially there was a certain amount of satisfaction among two groups of entities out there. First, the rest of the world that said this is a U.S. problem, created by the U.S. financial system and impacting the U.S. financial system. And then within the U.S. financial system, there was a divide between Wall Street, who had overproduced and over-consumed structured finance, and we're now living with the consequences of that behavior, and smaller banks, smaller local and regional banks who hadn't got into (structured ?) finance and who were saying, well, you see, okay, we were right to be more cautious.

This situation has changed very rapidly because of the contamination and contagion impact. So now Europe recognizes that they have to take steps, and you've seen some pretty dramatic step -- Ireland, Spain and Greece -- Ireland, Spain, Greece, Germany have all moved to basically guarantee deposits, doing something similar immediately to what Chancellor Darling did in the U.K. after Northern Rock.

There's now a big discussion on what else needs to be done, so there's now a recognition that this process, this fire, if you like, that started in the U.S. has consequences. Similarly, the smaller banks and the regional banks now have to face the reality that the consumer has been infected, that consumer loans, that mortgages all over the country are now at risk, and therefore their credit quality in terms of their lending portfolio is also at risk.

So the situation has morphed. And you'll hear me say morphed and morphed because I think that's the critical aspect to remember, that left to its own devices this process morphs into something more sinister.

What about the rest of the world? Ironically, those who had suffered the crisis earlier had much better initial conditions. That is true of emerging markets, and that is true of the U.S. corporate sector. Emerging markets had their crisis in '97, '98, all the way to 2002. And the corporate sector had its crisis in 2002 with WorldCom, Enron. Because of that, they entered this latest dislocation much better in terms of self-insurance, much higher cash, much lower debt. And therefore so far they've been able to navigate it better.

Where we go from here is a big question mark. Ultimately, everybody depends on two public goods that are produced by the U.S.: the reserve currency status of the dollar and the debt and liquidity and predictability of the U.S. financial market. And to the extent that these two public goods start deteriorating further, then there will be consequences even for the best-capitalized entities out there.

MR. WISEMAN: If I could turn back -- this is my last question before I turn it over to the audience -- thinking about turning back to the U.S. and thinking about the -- (word inaudible) -- of the U.S., thinking about the toolbox that policymakers have to work with, the legislation obviously was important, but getting it done as a statement of commitment was probably very important.

Given the numbers in the U.S. mortgage market, even the funding provided by the legislation could be viewed as modest. You also have the Federal Reserve moving instead of through a banking system under 13.3 of the Federal Reserve Act more directly to other market participants. That's clearly been another important tool. But could you comment a little bit on your view of the tools that are available to U.S. policymakers?

MR. EL-ERIAN: It's a difficult situation for policymakers. I would not like to be a policymaker right now because you're dealing with a very volatile and unpredictable situation that is moving very fast and your instruments are inadequate because of the nature of the crisis. So when you intervene, you will do so on the basis of incomplete information. And it is inevitable that a policymaker will create collateral damage by the choice of instruments that they have because the instruments are too blunt.

So it is very difficult to be a policymaker and it's very easy to criticize policymakers, but I think that that criticism is not valid. I think the reality is we're not in a world of first or second best for policies. There is no optimal policy response. So let me start with that because I think it's important. There's way too much second guessing go on right now in terms of policymakers where the reality is that you need to compensate for the fact that there is no perfect policy response.

What we're seeing, which I mentioned is really important, are a series of shifts from targeting institutions to targeting markets, from a series of national responses to a series -- to certainly talking about more global coordination, and from a sequential mind-set to a simultaneous mind-set. These are critical shifts.

Within that, the top of the economic stabilization plan that was signed into law on Friday, today's action by the Fed in terms of buying commercial paper directly from issuers are very important steps. They're important steps in terms of signals, and they're important steps in terms of necessary policy action. Whether they are necessary and sufficient depends on whether you get all these other things that I mentioned about that have to do with the payments of settlement system, the level of interest rate and the ability to attract capital.

MR. WISEMAN: Maybe we should go to the audience now for their questions, if the operator wants to do that.

OPERATOR: At this time we will open the floor for questions. If you would like to ask a question, please press the star key followed by the 1 key on your touchtone phone now. Questions will be taken in the order in which they are received. If at any time you'd like to remove yourself from the questioning queue, please press star 2. And again, to ask a question please press star 1.

Our first question comes from Alan Guarino at Korn/Ferry.

Q Hi, thanks a lot. Actually this is a question that's sort of trying to clarify a lot of buzz in the press, and it goes to whether we can simplify identifying sort of the cause, although it's not easy to do. So my question is that the buzz seems to be that the Community Reinvestment Act was a critical trigger that enabled members of Congress to sort of push financial institutions to, you know, greatly expand the credit available to low-income or lesser-qualified borrowers. And as a result, these products -- no income, no asset, et cetera, highly risky -- were made available to highly risky borrowers, and of course once those transactions were completed there was a bunch of low-quality debt introduced into the marketplace.

What I'm trying to determine as an independent voter, actually, is whether this was something that was sort of oriented towards the Democratic leadership, which is the way the press is sort of trying to spin this, or whether it was something that was sort of driven by the Republicans, if we can indeed make it that clear though of a distinction based on fact, you know, specific decisions made, et cetera.

MR. EL-ERIAN: Thanks, Alan. Alan, you know that there is a huge desire to simplify the blame game to a single act, a single person, a single institution. The reality is you cannot. So depending on who you are, you can either blame an act, you can blame rating agencies, you can blame policymakers, you can blame Wall Street executives, you can blame risk management systems, and the list is very long.

The reality is we're here because of a massive combination of factors. And that's why I said the beginning, and that's why, you know, I tried to write a book about it, is the reality is that the whole host of activities were enabled that the system's infrastructure could not support. Right? And the result of that is that you end up with having to clean it up.

Now, I suggested in the book that you can look to innovations as -- financial sector innovations as being one element that allowed this to happen; massive structural changes in the global economy, that was another element that allowed this to happen; and that the market was giving out signals for a long time, for about two and a half years, which most people tended to dismiss as noise. So there is no easy way to say it was this or it was that. It was an interaction.

The analytical framework for this is the Minsky cycles. Whenever you have a prolonged period of stability, that feeds actions that cause instability. And the global economy came from a long period of stability. If you remember a few years ago people were talking about Goldie Locks, not too hot, not too cold. They were talking about the great moderation, that you can have growth and no inflation.

Well, just like Minsky predicted and just like the capitalist system has shown over and over again, stability tends to breed instability, and instability will breed stability. And that's the dynamics of a capitalist system. You can cut off those tails, the bad left tail and the favorable right tail, you can cut it off, right, as some societies have tried to do, but in the process you end up with a much lower average growth rate over time.

So I think what we're going through here is new in terms of the actors, but it's pretty old in terms of the cycles that we've seen in the past. And there is no easy way to say oh, it was due to this or that. It was due to a whole combination of factors that were enabled at a time when the infrastructure on the market side and on the policy side couldn't support it.

Q Thank you.

OPERATOR: Our next question comes from Weston Hicks at Alleghany Corp.

Q Yes, good morning, Mohamed.

MR. EL-ERIAN: Good morning.

Q I was curious to get your opinion. You know, we're all aware that the, you know, the magnitude of leverage in the economy is unprecedented, you know, as measured by total credit market debt to GDP. And I'm curious if this imbalance can be resolved without, you know, a fundamental political response to the lack of income growth by, you know, a vast majority of the U.S. population over the last seven or eight years and also to what extent, you know, the resource competition plays into this from the point of view that higher energy prices appear to be, you know, sort of hit the tipping point in terms of the ability of the bottom 50 percent of the U.S. population's ability to sustain their existence in a highly leveraged situation.

MR. EL-ERIAN: Your question's critical because it raises a cyclical issue and a secular issue. The cyclical issue is that in order to accommodate the unwinding of the excessive leverage in the system you need a new balance sheet. You need a balance sheet to be able to step in and absorb the -- all this that's coming, because after all, if you think, you know, what does an institution that's over-leveraged, what can it do? It's not rocket science. It can only do three things. It can either raise new capital and/or sell assets and/or sell businesses. And if raising new capital becomes difficult as it is now, you have to accelerate the other two. And if everybody's trying to do the other two at the same time, it won't get done.

So the only way you can start solving this is through bringing in a new balance sheet. The new balance sheet right now in terms of the net creditor situation resides in the rest of the world. So even though the Treasury and the Fed can step in, ultimately as the U.S. still runs a current account deficit, this balance sheet has to be financed on the rest of the world. And that's where the link from cyclical to secular is important.

The secular side of all this is that the rest of the world is benefiting now from a migration of growth dynamics and wealth dynamics that the -- what we have, the middle class and a number of developing countries coming on stream, and starting to be a partial offset. Part of that, of course, puts pressure on resources over the long term. But the other part is it gives them the wallet to be able to step in and provide the balance sheet.

And if you remember the last council event I was involved in in New York had to do with sovereign wealth funds, and it's amazing how quickly this thing has turned. This was back in October or November when people were worried that by providing capital to the U.S., sovereign wealth funds would be not only owners of assets but controlling assets. And, of course, today the sovereign wealth funds have stepped to the sideline.

So your question raises two critical issues, which is no matter how we come out of this cyclical -- how quickly we come out of this cyclical disruption, we should not lose sight that the secular forces are one of moving from a unipolar world where the U.S. is dominated in terms of growth to a multipolar world.

Q It would seem to me that if, you know, if I were China sitting on $1.3 trillion or whatever the number is today of dollar assets with an emerging middle class, nothing could be better for me than a deflationary bust in the U.S.

MR. EL-ERIAN: You know, it's one of these things where you want -- be careful what you wish for because, as people are learning very quickly, when you deflate the largest economy in the world and the one that provides the public good in terms of the reserve currency and in terms of the global financial system, there are a host of unintended consequences.

Q Right, right. It morphs again. (Laughs.)

MR. EL-ERIAN: Right, it morphs again. So you can't control it, right. And that's ultimately the situation we're in is nobody can really predict when you put these public goods in play, no one really predicts -- can predict the consequences of that.

Q Okay. Thank you.

MR. EL-ERIAN: Sure.

OPERATOR: Just a reminder, if you'd like to ask a question please press star 1. And our next question comes from John Baker of Baker Capital.

Q My question has to do with potential sources of stability going forward and whether you think they -- or what portion of them do you think might come from a regulatory, even a coordinated regulatory approach versus market discipline? And if you could, comment on what others have said. Three sources of this current instability would be some combination of the over-leverage or, said another way, lack of capital in the banking or the financial or the shadow-banking system; secondly, a tremendous mismatch of asset liability maturities; and then third, the credit quality of the assets that are generated.

MR. EL-ERIAN: Thank you. I mean, this question fits in very nicely with the previous ones, and particularly the observation that stability tends to lead to instability. And I think what the regulators and the regulatory response is going to focus on is how to shift from pro-cyclical regulatory response to a counter-cyclical regulatory response.

What is clear is parts of the regulatory response or part of the regulatory framework, to be more specific, is pro-cyclical. So when something goes wrong, it forces certain behavior to make things go -- get -- go even worse. And when things go well, it relaxes and a sense of complacency comes in.

You see this in terms of capital-raising. During the good times there's very little pressure on institutions to raise capital, and institutions will not raise capital on their own willingly during the good times because it is costly. And you won't do it if others aren't doing it to because it's a relative game, after all. And of course, when the cycle turns and there's need for capital, the ability to raise capital declines.

You see this also in terms of valuations. You see it in terms of certain models, the so-called value-at-risk model that's used in the private sector. All that tends to get the system pro-cyclicality that makes the overshoots on the way up and the way down much worse. So the issues that you talked about in particular are those that I suspect are going to be a focus of the regulators.

In the short term, imposing counter-cyclicality leads you to do things that people get nervous about, not because the action itself is problematic -- it is for some it's not for others -- but because you're changing the rules of the game in an unpredictable fashion. So let me give an example: banning of short selling, attractive because you take off the pressure on financial institutions that come from those that are shorting their assets; unattractive because you change the rules suddenly and you bring in people who are going long and short at the same time, but suddenly they can no longer go long because they can no longer short.

Second example from recent history: insuring money market funds. You do that to stop to be counted -- to counter an outflow of money market funds because one of them has broken the buck. The minute you insure money market funds, bank deposits don't look as attractive, so you have to go back and try to figure out what are you going to do about the money market accounts.

Alternatively -- and Germany's discovering this today -- Germany did the other thing. Germany went and guaranteed all bank deposits, and now there are outflows from the money market segment back to the bank deposits.

So in the short term, using regulation to be counter-cyclical is a very complex issue because of the unintended consequences. But I think on the long term your points are absolutely right. There is going to be a need to go back and figure out how when it comes to capital, how when it comes to asset quality, how can you make the system counter-cyclical as opposed to pro-cyclical.

Q But do you think that there is even a conceptual grasp about a way to avoid a set of assets generated that would yield potential social losses of multi-trillion dollars?

MR. EL-ERIAN: If you're willing to cut the other tail, which are a set of assets that allow the economy to fulfill its potential even higher. And to give you an example is it's not about the assets themselves; it's about the overproduction, overconsumption of the asset, so structured finance is a very powerful tool if used properly. It allows you to lower barriers to entry. It allows you to achieve more cost-effective outcomes that are welfare enhancing. But the minute they're abused, right, then you -- the overproduction, overconsumption tends to hurt you.

If we had had this call two years ago, I suspect there would be a question about, you know, isn't it great that structured finance is allowing for these structured mortgages that enables people that wouldn't otherwise be able to own a house to own a house because they are borrowing from their future income? Of course, today, that -- those exotic mortgages were totally abused and we have the other consequences of foreclosures and people losing their homes.

So the balance is the issue, and the political decision -- this is a political decision -- is how much of the right tail, how much of the beneficial tail for society are you willing to give up in order to clip the left tail or the adverse tail? And that is a political decision that requires a lot of judgment.

Q Thank you.

OPERATOR: Thank you. Again, if you would like to ask a question, please press the star key followed by the 1 key on your touchtone phone now.

MR. WISEMAN: It's Michael Wiseman. I think we have time. This is probably going to be the last question.

OPERATOR: We are currently holding for questions, sir. And the next question comes from Brian Cavanaugh of Medley Capital.

Q There was an article in The New York Times this morning that spoke briefly about the possibility, I think it was suggested by one of the comments in the op-ed page, of increasing capital requirements as essentially markets go up and decreasing them in environments such as this. Do you have any thoughts on that sort of suggestion?

MR. EL-ERIAN: Yeah, I think, Brian, that's one of the counter-cyclical elements that's going to come in. I think it's the right thing to do. And unless you force it on the system, unless you make sure everybody's doing it, no individual institution will do it. So I think that that is the sort of the things that we're going to see coming out once this cycle calms down. But that speaks directly, Brian, to the need --

MR. WISEMAN: I think that's probably the end. We had promised Mohamed that he could go back to work at this point.

MR. EL-ERIAN: Let me thank everybody for dialing in.

And let me thank you, Michael, and the council for inviting me to this.

MR. WISEMAN: Thank you.

I think we're done.

OPERATOR: All right. This concludes today's teleconference. You may now disconnect.

(End.)

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