Mohamed El-Erian has a new book coming up this month. The veteran manager is well-known in the alternative investment community as the celebrated ex-president and chief executive of Harvard Management Company (HMC), the entity that manages Harvardâ€™s endowment. He joined Pacific Investment Management Company (Pimco) in December. His book called â€śWhen Markets Collideâ€ť puts the current credit crisis in a global macro-economic context, looking at market issues but also monetary policies. The book, according to an interview, in the latest issue of Barronâ€™s reveals that EL-Erian is not very favorable to the Federal Reserve Boardâ€™s recent actions. Well, he hardly is the only one. We haven’t read his book yet. But the interview provides an interesting aspect of his criticism, and that is the Fedâ€™s radical decision in March to open the discount window to investment banks.
El-Erian’s thesis is that opening up the window will create a “realignment of the financial system,” something that looks like a cascade of events, including negative ones. In the Barron’s interview, he describes theÂ realignment proceeds in four steps, leaving the best for the end.
â€śFirst, it will be very difficult for the Fed to withdraw the window once it’s introduced. What’s temporary will become permanent”.
The current window expires in September.
â€śSecond, once the window is permanent, these institutions will be subject to greater regulations aimed at de-risking. If you’re a senior bondholder, you’ll do well, and if you are an equity holder, you’ll be diluted, because A) the institution is going to be issuing more capital and B) the return on equity is going to come down. That action has very different implications depending on where you are in the capital structure”.
Step 3: Weâ€™ll see the lines blurring even more between investment banks and commercial banks. Here is how:
â€śThird, these de-risked institutions are going to look for deposits as cheap funding. That will cause a wave of mergers and acquisitions in the financial system as they look for small commercial banks they can buy. If they are going to be regulated like commercial banks, they will try to benefit from what commercial banks have, which is access to cheap funding.â€ť
Step 4 is the most interesting aspect of the analysis: The final result will be that alternative investment managers will want to play investment bankers. Hedge funds and private equity firms will be able to move into the space vacated by the banks without incurring much competition from the sovereign wealth funds. Interesting point, isn’t it, considering that sovereign wealth funds are the entities with the real deep pockets. El-Erian reminds us that while sovereign wealth funds provided massive capital to the U.S. banks and contributed to their recapitalization, they can’t really invest more than 9.9% without hitting regulatory limits. All the better for the hedge fund species. There will be winners and losers of this credit crisis. And hedge funds have a shot at winning.Â
Weâ€™ll keep you posted, possibly with a book review on our website.
When Markets Collide: Investment Strategies for the Age of Global Economic Change by Mohamed El-Erian Mc-Graw Hill, Hoboken, N.J., 2008, 344 pp., $27.95.