The 'cardiac arrest'

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Caption: Mohamed El-Erian, CEO PIMCO

The immediate impact of Lehman’s collapse

Mohamed El-Erian: Lehman was a major counterparty to many swaps. So even though you may have no collateral, they didn’t owe you money, and you didn’t owe them money, you had portfolio exposures. You had a certain position on that was put up through Lehman. So if Lehman disappeared you would wake up with the positions no longer existing. So the key issue for us on Monday morning was how do we quickly crystallise the Lehman positions and replace them so that our clients would be no worse off? Now that’s easy to say, to actually do it is quite hard.

Caption: The “Cardiac Arrest”

Mohamed El-Erian: We were very worried because the most important element in a financial system is trust. If trust disappears then everybody steps back to the sideline and waits and nothing happens. It’s what economists call the “sudden stop”. Suddenly, everything stops. It’s a cardiac arrest of the system, alright, and you can be the arm or the hand or the leg, if you get a heart attack everything stops. So the concern as an economist, the concern as a market participant is what happens when you get a sudden stop. The first thing that happens is that nobody trusts anybody because no one knows what other people’s exposures are and therefore the whole system grinds down, and that’s what happened during the week.

Caption: The implications of the Reserve Fund breaking the buck

Mohamed El-Erian: There are two elements to that: there’s what we were seeing with our market participant spectacles on, and what we were seeing as individuals. From the market side, we were seeing a cascading failure, that sector after sector that were deemed very solid were freezing up, and we saw that in the most critical part of the financial market which is cash and collateral transactions, where you are taking no risk. The example I used and you know in California we are a car culture, and we have the most efficient “drive-thru”. If you go to a McDonald's you’re in and out in thirty seconds. Why? Because you have one window where you pay and the next window where you collect your order - and you’re talking about ten metres between the two.

Imagine that you turn up to one of these drive-thru, and you put in your order, and you go to the first window and they say five dollars, and you say well here’s my five dollars but I want my Big Mac immediately, and they say I’m sorry you’re just ten metres down, go ahead you’ll get it at that point, and you no, no I heard that yesterday. At Burger King, someone was silly enough to put their money out and didn’t get their burger, I want my burger now. The answer is well the system doesn’t allow you to have your burger now, the system assumes some trust and look it’s only ten metres, and you say no I can’t take that risk. You go away hungry with money and at the second window, the kitchen, which has all the meat, all the bread ends up by not producing the burger and that goes bad. That is what happened. There was a cascading failure through what we call the payments and settlements system – trust disappeared.