One L of a global banking crisis

By Jon Markman

One of the world's leading authorities on the global financial system confirmed something that we suspected long ago: This is the market from L.

That letter is important if you care at all about the future of your money, home and job, because it depicts Mohamed El-Erian's view of the shape of a painfully stretched-out global recession over the next couple of years.

Celebrated for guiding big money at Harvard and Salomon Brothers before taking on the task of steering $865 billion at bond giant Pimco last year, El-Erian believes that the solvency issues now challenging big U.S. banks are destined to spread out into a full-blown economic dislocation that engulfs and endangers innocent bystanders the world over.

In an interview this week, he insisted that regional banks and local governments can no longer stomp their feet and claim they are immune from danger because they did not speculate on high-risk real-estate loans or structured finance: Collateral effects are going to crash into every institution that has ever lent a dime as excessive levels of debt are violently wrung out of the global financial system.

"I live in a world where crisis management is the norm, not the exception, and you learn a few things" El-Erian said. "You learn never to underestimate the destructive power of negative feedback loops."

L is for 'long term'

The insidious loop now has spun its way from Wall Street to the everyday lives of Americans as a financial crisis has become an economic crisis. Damaged money-center banks are lending less, leading to lower levels of production and curtailed expansion at companies. That has led to job cuts, which in turn have led to cutbacks in consumer cash flow and spending, which are feeding back into creating problems for credit card, auto and home loans made by smaller banks. Those troubles will in turn lead back to a diminished appetite to lend locally for projects with the slightest whiff of risk.

What makes El-Erian stand out among so many skeptics today is his view of the length of time these loops will need to play out. He argues that current stock and bond valuations are still so lofty, even after recent declines, that they suggest most investors believe solutions will come quickly -- creating a V-shaped recovery.

In contrast, El-Erian thinks U.S. government action has been so slow and timid that the recovery will instead drag out into the shape of an L and that it will curve upward into a U only when regulators and lawmakers worldwide are bludgeoned by losses to coordinate their approach despite dramatic regional differences in growth and indebtedness.

"Policy change in Washington, D.C., has been too little, too late," he said. "In a crisis like this, leaders have to be much bolder." He gives Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke an A-plus for effort but only a B-plus for execution and outcome, which is not good enough to effect a swift recovery.

Sitting out the stock market

A big part of the problem, he says, is that U.S. financial leaders have failed to communicate the extent of the problem, insisting that everything is fine and thereby creating false expectations. He also believes that the Federal Reserve has erred badly both by taking on too many responsibilities and by not prioritizing them effectively. The Fed, he says, started with this mandate: to guide short-term interest rates in a way that supports U.S. economic growth without causing inflation. In March, it appeared to add another mandate: to promote financial stability by mediating deals to keep faltering broker-dealers from collapsing, as it did by assisting the takeover of Bear Stearns by JP Morgan (JPM, news, msgs). And the Fed then appeared to add one more mandate when Bernanke began to talk up the value of the dollar, which is something no predecessor had done.

Continued: Conflicting mandates

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