Mohamed El-Erian Exclusive: The Real Debt DealJuly 18, 2011
Is capital intended to be invested in innovation and development to solve problems, or will it continue to be used merely as a speculative device in the casino of the U.S. economy?
To get answers, we recently spoke with Mohamed El-Erian. He is the Chief Executive Officer at Pacific Investment Management Corporation (PIMCO), which is responsible for over $1.2 trillion in financial assets, with holdings ranging from America’s mortgages to some of our own government’s debt. El-Erian oversees PIMCO’s investment policies and strategies, and is a lead portfolio manager focusing on global tactical asset allocation strategies.
He has been a strong advocate for more aggressive banking reform since the financial crisis.
“By either enabling or encouraging financial engineering, that has taught making people believe that you can make money out of simply circulating bits of paper around the financial system. Financial engineering is very powerful if it serves the end consumer. It’s very dangerous if it allows a tremendous amount of leverage within the financial system,” says El-Erian.
Also critical to fixing our economy is to know where, exactly, we are going. El-Erian compares our current system to the 405 — but one with no rules and no speed limit.
“A well-functioning 405 is the 405 that has very clear rules—it has a speed limit, it has lane discipline … And if you don’t have rail guards, guardrails, then the accident can get really big. So what happened is the system started out being really well administered, and then people came along and said, “Wow, can we make it even more efficient because we now have faster cars,” we have financial engineering. So let’s increase the speed limit… we didn’t set clear lane discipline… And then things started going wrong and next thing you know, you have a huge pileup… Now that’s the system that you’re trying to undo. The easiest way to undo it, which is very costly to society is to say from now on, the speed limit is 10 miles an hour.”
“Remember in the beginning in some of the better economy that had a lot of money, they would build a road going to nowhere, right? That’s when that road will become a racing track.”
“When a road becomes an end in itself, you encourage all sorts of bad behavior. We should never lose sight of the road being a means to an end,” says El-Erian.
Dylan: Welcome to Episode 64 of Radio Free Dylan. Today, we have a conversation with one of my teachers and a friend of mine and somebody who has a fundamental value system that goes to a real economy that solves our problems, a financial services business that supports a real economy and very clear rules to go about doing that. Mohamed El-Erian is the Chief Executive Officer at Pacific Investment Management Corporation, where they are responsible—they have custody of in excess of $1 trillion in financial assets among the many things that they are responsible for, of course, are many of America’s mortgages from time to time and our government debt, which they also do purchase to varying degrees on a regular basis. Most important about Mohamed, in addition to his work at PIMCO, is the understanding that his view of the role of capital on the earth is that capital is intended to be invested in innovation and development and problem-solving; that it is not intended to be either invented or simply used as a speculative device. One of his metaphors that I think is very powerful is the financial system as a freeway and the point of being on the highway, the 405 or whatever it may be, is not to simply drive but it’s because you’re trying to go somewhere. And when the financial system no longer actually is trying to take us somewhere or serving us, you get all sorts of bad driving, which is what we have been suffering from. And with no further ado, I’d like to share with you the thoughts and ideas as to how we might be able to actually begin the process of healing our sick financial system with Mohamed El-Erian.
Let me just give you a sense of what I’m trying to achieve right now. The book is almost done and the banking chapter for me is the most difficult chapter because I want to be able to represent sort of the purest interpretation of why banks exist, what capital is, how capital should flow or what the idealized intension of it is, at the same time, I want to acknowledge what exists today, to go back to your analogy of shutting down the 405, which ironically they’re now doing, and get a little bit of a sense from you as to how, even if you can’t necessarily – like what the best way to deal with “too big to fail” is in the context of reality and what the best way to deal with leverage is in the context of reality, etc., etc., and basically just get your feedback from a practical standpoint to say yes, the ideal situation is that you have these highly capitalized banks and you have capital wherever it is, we don’t have that and these are our options and choices as to how we make it so that’s less the case, basically.
Mohamed: I will start from the ideal world that you have well-capitalized banks run by people who have aligned incentives within a well-regulated and supervised system. So you need three conditions, all right? You need the institution to be strong, you need the managers to be well-incentivized, and you need the system to be well-regulated and supervised.
Dylan: So can we talk about that at great length individually?
Dylan: How do you define a strong system – let’s start with the system itself being strong.
Mohamed: Okay. So the system must start, it must start from the understanding that banks are a means to an end and not an end in themselves, okay? So I always say if you were to go back and mark the stage at which the financial service industry got out of control, it’s when it stopped referring to itself and it stopped being referred to as a financial service industry and started being referred as a financial industry. Banks, asset managers, hedge funds, insurance companies are here to serve the real economy. They have no standing on their own. And it’s critical that the system always linked the financial service industry with economy, otherwise you get into problems.
Dylan: And how is it that the system can be manipulated to delink the financial services industry and the real economy?
Mohamed: By either enabling or encouraging, okay, financial engineering that’s taught making people believe that you can make money out of simply circulating bits of paper around the financial system. So the financial engineering is very powerful if it serves the end consumer. It’s very dangerous if it allows a tremendous amount of leverage within the financial system.
Dylan: Which is where we currently stand, correct?
Mohamed: Which is where we currently stand and where we stood even worse before, unfortunately, liabilities were shifted through the budget, the public sector.
Dylan: And so as a – listen, in an ideal world, you could walk into the room and you would do – what would be ideal solution to this problem of getting rid of the leverage if you weren’t concerned about disrupting the flow of the economy? What would be – where, in other words, if you’re trying to get from here to there, where would “there” be?
Mohamed: Well, there would be – so start with the three principles – there would be first with banks that are not highly levered, which is another way of saying they have enough capital—they have enough of a cushion so that they can take a bump without bringing the real economy down or without holding the public balance sheet hostage.
Dylan: And how do you go about getting from here to there?
Mohamed: You get the to recapitalize and you get them to safely deliver. And safely—not safe for them, but safe for the system.
Dylan: Can you elaborate?
Mohamed: Sure. I mean, one way to de-lever is to stop lending, right?
Mohamed: Okay, however, if you stop lending, you trick the economy up, you trick your sector up, right? And you end up having problems that feed back into everything, so you have to safely de-lever.
Dylan: And what – the only mechanism that would seen possible to do that would be to actually write down some of the debt. In other words, that the leverage is a function of how much money we have plus as a fraction underneath how much money we owe, right, and so it seems that the only potential way to de-lever without stopping lending is to literally agree that it is impossible that a lot of the debt that exists, whether sovereign debt or whatever it is, is simply not going to be paid back because the money doesn’t exist. Is that not correct?
Mohamed: So that goes back to a much bigger issue which is we have a whole host of contracts, Dylan, that were entered into during better times that unfortunately have to be rewritten.
Dylan: Meaning contracts of money owed to various parties.
Dylan: Based on some sort of underlying principle.
Mohamed: Yeah, you know, old people feeling entitled to things, right?
Mohamed: And you see this; you see this in the reaction of banks, you see this in underfunded pension systems, you see this in the debate on entitlements. When you de-lever an economy, by definition, certain promises are not going to be met, and the question is how do you share that burden. And so far the burden has been fed mainly by the real economy and households. Bond holders have been made whole for the most part, banks have been recapitalized using everything from a very steep [inaudible] curve to guaranteed borrowing that they had to capital injections.
Dylan: So if you were to look at some of the sort of very fundamentalist views of reform around banking, and I’ll give you four examples. I’d be interested to know whether you feel these things are achievable and if they are achievable, how you would effect them, whether you would actually literally have to do it or could you do it through some sort of synthetic mechanism? The first and most obvious one is the premise of the “too big to fail” financial institution, and I don’t just mean that by virtue of large institution in that it has custody over a large percentage of the assets, but also too big to fail in a sense that it is a highly levered institution, which makes it more fragile. How would you – how could any nation address a “too big to fail” bank problem?
Mohamed: Well, it’s most advanced in Switzerland, so Switzerland has recognized that their two banks, UBS and Credit Suisse, are way too big for their economy. And they are very aggressively trying to do two things—one is de-lever those institutions, and two is get them recapitalized. So if you want the extreme example of someone trying to reduce a “too big to fail”, it is Switzerland.
Dylan: And how are they doing that? Are they writing down debt?
Mohamed: They are – they are imposing much higher capital requirements than elsewhere in the world, and they are “encouraging” [inaudible 11:05], the banks are continuously de-levered.
Dylan: Would you point to Switzerland as a model for how Western central banks and central banks and legislators, in general, should look at addressing “too big to fail?”
Mohamed: I would point to Switzerland as being the most advanced, so they’ve gotten from debating the issues to actually trying to make it work. You know, a lot of these things are going to be done according to what the Chinese do very well, which is you know what your destination is, you start down the road, you can’t specify every step of the journey, but you know where you’re going, you know where you’re going to start, and you have to be open to adjust on the way down. Part of the problem that has occurred in this country is that we tried to specify every step of the journey. And trying to specify every step of the journey, we incurred a tremendous amount of lobbying and, therefore, efforts have almost been dead on arrival. Now, we are almost three years after financial crisis, and ask JPMorgan what has changed and they’ll probably tell you very little. They’re concerned about what’s going to change, but three years afterward -- go and ask UBS or Credit Suisse and they’ll tell you, “Oh, quite a lot has changed.”
Dylan: Right. And that’s a direct function of the political environment, which allows obviously any special interest, in the case American banks, to influence legislative decision, which you’re saying that the degree of influence of UBS on the Swiss government is lesser, is that the implication?
Mohamed: I think the Swiss government is more intent on getting things going and is not trying to design the whole journey. It knows where it wants to get to, it’s starting the process, and it knows it’s going to have to cost correct as it gets more information. The alternative of trying to pre-specify every step is strategically much more fragile because we then attract all the people that resist change.
Dylan: What of the agenda for transparency and specifically in the financial system as it applies to whatever the actual level of risk is in the credit default swap market and in the credit derivative market, which is where so much of the lending risk is warehoused but very difficult it seems to assess how much actual risk is there because it is not a transparent marketplace nor is it a marketplace that really causes a lot of collateral to be posted.
Mohamed: Okay, so this is why in the moving a lot of these transactions to exchange is so important. It’s also why the banks have been resisting so well. So as you know, there are efforts supported by people like us to move things to exchanges, regulate and support that too. The joint interest is three-fold. One is you can create a transparency, and greater transparency means better functioning markets. Second, you reduce the cost of intermediation. Third, you allow netting, so you reduce leverage in the system.
Dylan: Can you elaborate on netting a little bit?
Mohamed: Sure. So when you have a exchange – suppose that I want to do four transactions and they are all opposing and I’m forced to go bilaterally. So I would go to one bank and do one leg, I’ll go another bank and do another leg, I’ll go to a third bank and do the third leg, and I’ll go to the fourth bank and do the fourth leg, right?
Mohamed: Leverage in the system now is on account of all these four things, even though at the end of the day you could net it out because [inaudible 15:09]. Okay?
Dylan: So the mathematical risk that is implied in the total transaction is actually very small.
Mohamed: Right, very small, it gets netted out by the exchange. Similarly, suppose that a bank has sold me something and has bought it elsewhere, but it can’t put me against the other person that’s in the middle of all this.
Dylan: So the other risk appears to still exist even though it’s actually been purchased by you in this instance.
Mohamed: Correct. So netting has a huge advantage in terms of reducing risk. It has a huge advantage in terms of reducing transaction cost and it has a huge advantage in terms of improving transparency.
Dylan: Is the only barrier to pushing these types of instruments onto exchanges the profitability of the spread or the margin from the banks that trade them off the exchange?
Mohamed: Well, there’s two things. One is that they will make less – it’s like you having to go to a travel agent or you being able to go to the internet, right?
Mohamed: So one, they will make less profits. And two is that they will lose some of their information advantage because transactions will be transparent to all.
Dylan: So the trading edge is diminished, as well.
Mohamed: Correct, correct. I mean, what is the advantage of “the sell side,” the banks. Is it code there in the flow – they see the flow; you hear that all the time, right? Here, everybody will see the flow.
Dylan: What of the argument that it’s impossible to put the swaps market on an exchange because the collateral that’s being used, whether it’s a large corporation’s balance sheet or a regulated insurance portfolio of some kind, is such that you actually can’t post collateral because you’re dealing with sort of large fixed capital assets that are being –
Mohamed: Give me an example.
Dylan: So I am General Electric and I’m accepting swaps against my balance sheet on the value of all of our industrial equipment, but I don’t want to have to post capital – I don’t want to have to liquefy our industrial base; I just want to be able to capture the yields, right?
Mohamed: [cross-talking 17:33], right, that’s whether you post collateral or not, right?
Mohamed: Right, and that is a judgment that has to be made, has to – how risky are you as a counterpart. But that judgment has to be made at both the exchange level and at the bank level. So supposed that I, in order to gain a competitive advantage, I the bank, right, come to you and say, “Hey General Electric, you can do everything you want without posting collateral…”
Mohamed: Right? It is in mind for us to do that.
Dylan: Because now GE wants to work with you as opposed to the guy who wants him to post collateral.
Mohamed: Correct. And then something goes wrong, the system is at risk.
Mohamed: Think of AIG.
Mohamed: Okay, that is exactly what AIG did.
Dylan: As they basically said you don’t need to post collateral because you’re triple A, whoever you are.
Mohamed: Correct. And for them, it looked great because they could do more and more and more of this business that earned fees, but then when it goes wrong, it goes wrong in a huge way. And then you ask who is it – what’s the capital behind all this, and suddenly there is no capital.
Dylan: Right. And so I guess the question is how do you fix that? How do you address that risk?
Mohamed: You know, this goes back to the whole – let’s go back to the 405. A well-functioning 405 is the 405 that has very clear rules—it has a speed limit, it has lane discipline, so you don’t need to go at the speed limit, you can go slower but stay on the right lane, and it has barriers to stop people going off the road in case they slip. Now, if you will relax one of these things, problems start. If you relax the speed limit, then people can go too fast, they can have accidents. If you relax lane discipline, then you can end up having an accident simply because people are on the wrong lane. And if you don’t have rail guards, guardrails, then the accident can get really big. So what happened is the system started out being really well administered, and then people came along and said, “Wow, can we make it even more efficient because we now have faster cars,” we have financial engineering. So let’s increase the speed limit, let’s increase – pretty soon there was no speed limit. But we didn’t set clear lane discipline, so people who shouldn’t be driving with no speed limit in the left lane – they should be really in the right lane and ended up in the left lane. And then things started going wrong and next thing you know, you have a huge pileup and then you found out that you didn’t have the guardrails. Now that’s the system that you’re trying to undo. The easiest way to undo it, which is very costly to society is to say from now on, the speed limit is 10 miles an hour.
Dylan: And just slow everybody down, just [cross-talking 20:41]
Mohamed: Slow everybody down. So you reduce accidents but you start having efficiency costs.
Dylan: Because very little ever happens.
Mohamed: Yeah, so people don’t get there very often, they consume a ton of gas, so we have to find in-between, and that’s actually what – so one isn’t saying you know what, first of all, we going to slow the speed limit gradually. Secondly, we’re going to strengthen the cars; we’re going to put in more airbags…
Dylan: And the airbags in the metaphor is more capital requirements.
Mohamed: More capital.
Dylan: So that when there’s an impact, the whole car doesn’t get vaporized as the Western banks did in 2008.
Dylan: And your argument is the only way to look at solving, because we’re dealing with a simultaneously occurring multi-million variable mathematical equation that is not just the global financial markets, but the global economy is you have to have a clear objective and value system and then set down a path to figure out the best way to do that with the 21st century awareness of our own ignorance to solve these problems and as such our desire to acquire more information and adapt as we proceed.
Mohamed: Correct. And ultimately understand that the 405 is a means to an end.
Dylan: That driving on the 405 itself is not an outcome.
Mohamed: Remember in the beginning in some of the better economy that had a lot of money, they would build a road going to nowhere, right? That’s when that road will become a racing track.
Dylan: Right, well, what else are you going to do?
Mohamed: And then it would create accidents, right?
Mohamed: Okay, so when a road becomes an end in itself, you encourage all sorts of bad behavior. We should never lose sight of the road being a means to an end.
Dylan: Can I discuss the tax code with you briefly relative to flow of capital?
Dylan: So if we understand that the objective is to get to lower levels of capital and address the barriers that we’ve discussed, particularly the swaps market and the exchanges – actually, before I do tax code, would you – is there any value in actually breaking up the large financial institutions in the classic Teddy Roosevelt too big to fail sense?
Mohamed: Yeah, that’s the extreme. That is the, you know, let’s put the speed limit back at 10 miles an hour, right? So the extreme is what I call narrow banking. You say an institution, the minute you receive the profit, you can only do very, very strict lending and investing in government paper. I’ll take it to the extreme, okay?
Mohamed: So you have a very sound banking system. However, the amount of activity that will finance will be a fraction of what you would like it to be. That is a – so if you go to a narrow banking system in which you spin off every activity, other than deposit gathering and lending and investing in government paper, you have a safe banking system; there’s no doubt about it. It’s actually very difficult to blow up that banking system. You can blow it up by making stupid loans…
Mohamed: …but it’s harder, right?
Mohamed: So it can happen, but you incur costs.
Dylan: And the cost is basically the fixed capital that could be effectively lent or invested…
Mohamed: Correct, correct, absolutely correct.
Dylan: …is you’re basically you’re not harnessing all the potential capital that exists.
Dylan: Because you were saying basically it’s too dangerous if we let them harness all the potential capital because it could blow the system up.
Mohamed: Yeah. Harnessing the potential capital is fine, okay, creating stuff out of think air, right, and going to excesses and find.
Dylan: So what is…
Mohamed: Think of a Ponzi scheme. That’s a perfect example of a Ponzi scheme. A Ponzi scheme creates savings and investment out of thin air, right? So you give me a dollar and I go to the next person and say, “I’ll – so think of it as they typical pyramid scheme, which is a license for you to go out and get money. So I sell you the license for a dollar because I say you can go out and you get two dollars. If you go out and get it at two dollars because the other people can get it at four dollars. And we go down the pyramid with all of us giving license to each other to create capital and create obligations until someone comes along and says “give me my money back,” and then the pyramid suddenly collapses completely. What happened with Madoff is an example of that. So you have to be careful that you harness real capital, not imaginative capital.
Dylan: So in the context of “too big to fail”, the need for capital, and the need for transparency, and the car wreck and the sort of aftermath of the car wreck, the burden of that car wreck being felt by households, retirees, etc., etc. Where would you begin the process of – in other words, what is your opinion of breaking up the banks and, alternatively, how would you even approach this issue?
Mohamed: So what I would do initially is first and foremost, I would raise the capital requirements for all financial – for all banks. Secondly, I would pursue the notion of SIFIs, systemically important financial institutions, and I would impose on them an additional capital charge.
Dylan: And that would be the initial overture that could be over – what duration would that do you think take to get to some point of stability in your opinion?
Mohamed: Financial stability or economic stability?
Dylan: Economic stability.
Mohamed: Yeah, that’s where it gets a little bit tricky because the banks will counter that they will not be able to lend. That’s where it gets a little bit tricky, and that’s where I would also pursue things like an infrastructure bank. I would overcome the ability of the bank system to hold the economy hostage.
Dylan: With a bypass lending mechanism of some kind.
Mohamed: With well-focused bypassed – with well-focused new mechanisms, especially for infrastructure, especially for elongated assets.
Dylan: So would you do that simultaneously? In other words, knowing that when you start raising the capital requirements that it’s going to inhibit lending, would you need to simultaneously almost to the capital requirement?
Mohamed: Yeah, I would even do it without – it’s so important that I would get moving. I go back to structural problems requiring solutions, right, and…
Dylan: Other components, so if you were basically to deploy capital, create some sort of bypass lending mechanism, you would be well on your way to being in a less dangerous environment just by doing those few things. Correct?
Mohamed: Correct, correct, absolutely correct. And you have to overcome opposition because both will be opposed.
Dylan: And the primary weapon of opposition will be the threat of further unemployment as a result of diminished financial activity from the banks.
Dylan: Can we talk about the tax code for a moment, and how much does the way we treat long-term investment relative to short-term investment relative to income through labor influence the degree to which we are truly capitalists in a sense? In other words, could or should the tax code more explicitly incentivize pushing and keeping capital in the real economy and be more prohibitive toward idle speculation and/or removing the capital for personal consumption?
Mohamed: So I have not looked at the tax code close enough to give you an intelligent answer, so I would, on this one, I would just repeat what I hear. So there are probably better people to talk to that than me.
Dylan: Okay, okay. I really appreciate your taking the time to have this conversation with me.
Mohamed: Are you kidding? It’s the other way around.
Dylan: So that will do for this episode of Radio Free Dylan. I’m Dylan Ratigan, and we’ll talk to you next time.