In an address to institutional investors on December 2, PIMCO CEO and co-CIO Mohammed El-Erian provided a comprehensive analysis of the current credit crisis, along with guidance for investment strategy.  Traditional rebalancing is not the way to go, he said, and investors should go up the capital structure instead of increasing equity positions.

“There is no reset button” to cure the credit crisis, El-Erian said.  “The dislocation is occurring at the heart of the financial system – not at the periphery – and it follows that the normal circuit breakers will not work.”

Current de-leveraging is “a process that is indiscriminate in its path,” he said.

To underscore how remarkable the current crisis is, El-Erian asked how an impartial observer would have responded just six months ago to the following possibilities:

• The next global crisis would originate in the most advanced financial system in the world;
• Newspapers would report that people are lining up outside banks to withdraw money – not in a third world country – but in the US and the UK;
• The Fed would announce six emergency policy measures, including at least one that was announced on a Sunday night;
• Congress would arm the Treasury Secretary with a “bazooka” (the TARP) to disburse funds to buy assets;
• Major portions of the financial system would be nationalized;
• Even after such unprecedented events, the financial markets would remain in a state of extreme crisis.

Such a thought would have been regarded as fringe predictions at best, he said but the truth is that everything has occurred, and much more.

“There is no master plan for fixing the crisis,” said El-Erian, and officials “don’t have the luxury” of figuring one out.  Instead, they have so far mainly focused on ad-hoc crisis management steps.

Policy decisions are following a sequential path, addressing successively wider concentric circles of asset classes, El-Erian said.  Officials initially focused on short-term assets and inter-bank lending, while subsequent steps were aimed at mortgage-backed assets and consumer credit.  But as the size of the targeted asset class has grown, more money is needed to stabilize the markets, and implementing responses has grown increasingly difficult.  The result is a sequential and drawn-out healing process.

How did we get here?

El-Erian ascribed the roots of the crisis to a concept first put forth by NYU professor Nouriel Roubini, who described a “stable disequilibrium” — a host of global structural imbalances that were well-known but nonetheless allowed the financial system to remain stable.

These imbalances included risk management systems that were too slow to evolve, a disproportionate focus on short-term results, and massive innovations that lowered the barriers to entry in the structured finance industry.

Underlying these imbalances were a natural human tendency to overproduce and over-consume, according to El-Erian.

El-Erian cited a series of de-leveraging processes triggered by the crisis.  Balance sheets throughout the global economy are contracting simultaneously.  “It is like a building on fire, and everyone is trying to get through the door at the same time,” said El-Erian.  “The financial system is slimming down,” he said, with consumers and the rest of the world following suit.

As a result, “every single asset class is under pressure,” he said, adding that the system cannot accommodate current levels of selling pressure.  Buyers can see the massive global de-leveraging and hold back until prices stabilize, but sellers cannot afford to wait, forcing prices lower.

De-leveraging is occurring throughout the economy, and not just in the financial markets.  El-Erian described a “massive economic slowdown” and forecast a GDP contraction of 4-5% for the fourth quarter over the preceding year.  Every single economic indicator has “fallen off a cliff,” he said.

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