By Mohamed El-Erian
July 15, 2008
Co-chief executive and co-chief investment officer of PIMCO
The financial system is at a crossroads. At current market prices, the system remains under-capitalized despite some $350bn of capital-raising over the past 12 months.
This realization drove the recent emergency policy statements from Washington. It is the second time this year that such dramatic announcements were made on a Sunday a phenomenon historically reserved for developing countries rather than industrial ones. It reflects the understandable eagerness to minimize forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function.
Accordingly, look for the official sector to encourage further capital-raising and work even harder to isolate the most vulnerable financial institutions and limit the negative spillover effects. For some institutions, especially the systemically important ones, this is likely to involve facilitated marriages similar to what occurred earlier this year in the cases of Bear Stearns and Countrywide. Others face the risk of explicit failure (as occurred this weekend with IndyMac, the California-based bank). In all these cases, equity holders would experience additional pain while mechanisms would be triggered to protect certain deposits.
This is a practical approach aimed at striking that delicate balance between laisser-faire and government control. Yet it has important limitations. It does not work for large institutions such as Freddie and Fannie thus the need for Sunday’s announcement of contingent equity and debt financing from the authorities. Also it cannot handle a large number of institutions facing difficulties. It is likely that additional steps will be needed, lest these limitations end up transforming the current economic and financial dislocations into something even more sinister.
(These are excerpts from the PIMCO site. It is worth reading the whole thing.)