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Archegos margin call, 'could have had system-wide effects': Allianz Chief Economic Adviser

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Queens' College President, and Allianz Chief Economic Adviser, Mohamed El-Erian joined Yahoo Finance Live to break down how Archegos will impact the banks.

Video Transcript

- Let's get right to it with Mohamed El-Erian. He is president of Queens College, Cambridge University, also Allianz chief economic advisor. Thank you for joining us, Mohamed. And I'm going to ask a very basic question. Because having long ago remembered, what was it, Long Term Capital Management, and then of course July of 2007, Bear Stearns, high-grade structured credit and enhanced leverage fund, why is this perhaps different? Why should we not be concerned about a contagion? Or should we?

MOHAMED EL-ERIAN: So we should not be worried about short term immediate narrow contagion. And I'll come back to what I mean by that. But we should take it as a signal of something we should keep on the radar screen, Adam. It is not LTCM. It is not Bear Stearn. This is an isolated situation of excessive leverage, concentrated positions, and derivative overlays.

So this was an accident waiting to happen. And it happened. Now we can ask, why did the banks not see it? Why did they allow it to happen? All of these sorts of things. But it did happen. But it will not cause a massive deleveraging of the financial system. That's what we worry about when these things occur. It may however lead banks to be more cautious about extending credit. And that in itself could be the longer term contagion from this.

- Now that's interesting there Mohamed. And I want to get back to what you were saying just about the risk that was taken here. Because we saw Goldman Sachs and Morgan Stanley exit their positions much earlier, getting out of this trade before Credit Suisse and Nomura did. And of course, we're seeing that reflected in those stocks over the last couple of days. What does this tell us though about, more broadly speaking, about what brokerages really have learned when it comes to risk management over the past, what, 10, 11, 12 years since the 2008 financial crisis?

MOHAMED EL-ERIAN: So there's going to be a lot of explanations going on right now within those firms. How did we allow the leverage to go so high? Let's not forget that this is someone who had legal issues less than a decade ago. I think typically, what you see is what I call the fallacy of composition. Each firm thinks that it can be the smart provider of leverage. It doesn't worry too much about other banks providing leverage till it's too late. And at that point, they do try to ensure an orderly exit. They tried that. They got together. But the inclination to move first is huge.

And once one bank moves first, or two banks in this case, then the others are left holding the bag.

- Would you expect the regulators to ask that question? I think it was Forbes actually pointed out the questions that should be asked. And you just hit upon it. How did the biggest banks in the world, Goldman Sachs, Morgan Stanley, how did they miss this?

MOHAMED EL-ERIAN: So they'll say it was a family office, that they didn't do anything illegal. And I think that's right. There's a question about internal risk management. That's a different issue. But the regulators, it's going to be hard for the regulators to ask anything about the legal elements. But they can ask about the internal risk management.

- Mohamed, when you mentioned the fact that maybe one of the possibilities we could see or a result of all this could be the fact that we could see a tightening in financial conditions, and then that of course, just leads to the question that if we do seem more cautious behavior, how will that be gone about? I mean, how would we see that happen? Because can it be done in an orderly fashion is I think the big question that investors are asking right now.

MOHAMED EL-ERIAN: So let me take you behind the sort of closed doors when these things happen. Every trader is asked to go and look at their book and assess, reassess the risk limits. So everybody's going to be not going back and let's say, look. Let's not have another accident. Reputational risk, financial risk, they're both higher now. So what you get is a natural risk aversion that goes on. And that may lead, I say may because we don't know, that may lead to somewhat less common financial conditions.

But there's a bigger issue I want to stress. This is the third near accident this year so far. We are in March and we've had three near accidents that could have head end system wide effects. And it tells you that when so much liquidity has been put in the system, there is excessive and in some cases irresponsible risk taking. And that's what investors should realize, is that there is a cost and there are risks to this period of very ample liquidity.

- Well, that goes to the next question about if there was this one family hedge fund, wouldn't there possibly be others out there, especially when you get into derivatives which have a very fundamental legitimate role in the system, but that also offer this kind of behavior to perhaps obscure who's really part of a deal?

MOHAMED EL-ERIAN: So we saw it in February with retail investors buying a margin of GameStop. We saw it with the hedge funds, remember, shorting 140% of the float. We've seen it now with a family office. And it tells you-- a lot of people have been saying the best thing to do right now is to lever. Why? Because financing is so cheap and so available. Now I have no issue if you are levering within a structure that someone else cannot delever.

But as we've seen, if other people can delever your structure, this is what the brokerage firms did to the family office. And they [AUDIO OUT] incredibly vulnerable. And that's the issue, is where has the leverage been taking on that's not just very high but that is vulnerable to other people forcing it down? Because when that happens, you get forced sales. And those are very messy, as we saw last week.

- Mohamed, when you talk about the fact that this could have been the third near accident this year. Could have had system wide effects. It didn't. When we see traders, investors, even larger institutions in this case, take a step back and reassess that risk out there, is that a good thing for the market? Because when you take a look at it, I think we do want a little bit more discipline in the marketplace.

MOHAMED EL-ERIAN: We do. We want [AUDIO OUT] the wheels. You don't fundamentally change the trajectory that you're going. But you slow it down a bit so that you minimize these excesses. So yes. If we learn something from this, if we learn-- it's as if you are driving on a freeway. If you've gone through three near accidents, maybe you should slow down a bit.

It doesn't mean you shouldn't be buying good stocks. It means you should be careful about how you finance all this. And you should also be careful that if someone else has an accident on your freeway and you are caught offsides, it's going to be messy. So this is a good time to internalize these lessons. The system is telling us that there has been excessive risk taking, or irresponsible risk taking, and we can't avoid in some cases, the collateral damage of that.

- Mohamed, let me use what you just said to shift into a broader discussion. For instance, Viacom CBS, I think you could make an argument, at least they would, that they're a good stock and that they've been harmed by this. Then you get the fed. Because you've talked about there is excess capital out there. And that's the fed. Are you saying that the fed should perhaps tighten sooner than that leading us to believe they will?

MOHAMED EL-ERIAN: So I've said for a while, Adam, what we need is the following three things to happen. Press harder on policies that promote high inclusive and sustainable growth, infrastructure, human capital development. Press much harder than that now, not in six months' time, not in four months' time, now.

Lift your foot very slowly off the monetary accelerator. Because we have ample evidence now that the benefits are very few. And the cost of it is so high. And press much harder on prudential policies, macroprudential policies to reduce financial risk. That is what we need to see.

We're not seeing two or three at all. We may see one. But we're not seeing two or three. And that's the problem we have.

- Mohamed, looking at the second quarter, we had the first quarter coming to a close this week. As we look for a future catalyst there, what's on your radar right now just in terms of what's going to propel future gains?

MOHAMED EL-ERIAN: So I would look at the recovery. I for one think that as long as we don't [AUDIO OUT] up with COVID infections, we're looking at a 7% plus growth for the US economy this year. And there's going to be lots of beneficiaries. So I would add our success in maintaining infection's low as we accelerate vaccines and unleash the economy.

This economy is poised to pounce and grow really rapidly. Look at this consumer confidence number. So [AUDIO OUT] keep a close eye on yields. Yields will continue to go up, not in a linear fashion, because every time they go up, we attract foreign buying, and we attract people who are a liability metric. So it's not a steady pace up. But it continues to go up. Keep an eye on that because that can shake the confidence we have in the liquidity paradigm. So those are the two things that I keep on my radar screen. And I reassess on a daily basis.