When Markets Collide: Investment Strategies for the Age of Global Economic Change

When Markets Collide: Investment Strategies for the Age of Global Economic Change | Mohamed El-Erian | Analysis of the Current State of Financial Markets in 2008

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When Markets Colli...

	When Markets Collide: Investment Strategies for the Age of Global Economic Change Mohamed El-Erian McGraw-Hill, 2008 - 304 pages average customer review:based on 32 reviews view larger image
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A Must Buy Book For The Chaos Ahead..

This new world order of financial chaos scares me to death. It is certainly not about me personally but rather my family and what I will leave behind for them.

I bought Mohamed El-Erian's book around the same time I bought Crash Proof: How to Profit From the Coming Economic Collapse (Lynn Sonberg Books). I found both of them to contain very valuable (and timely) advice, which helped, calm some of my fears and anxiety. With that said, I would have to rank Mr. El-Erian's book a little higher than Crash Proof.

Mr. El-Erian has written a very important book. Very few people understand markets as Mohamed El-Erian. He is able to analyze and develop strategies for the continuing credit crisis. His background in economics, government policy and investment banker help him to mold this chaos into a manageable entity. His insights are worth the price of the book. Believe me.

I hope you found this review helpful.

Michael L. Gooch, SPHR - Wingtips with Spurs: Cowboy Wisdom for Today's Business Leaders.

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Analysis of the Current State of Financial Markets in 2008

When Markets Collide, by Mohamed El-Erian, describes the ongoing evolution of the world's financial markets in terms of both the current path and likely destination. His approach is very much in the "Big Picture" style; don't look for specific investment recommendations or specific predictions of market behavior. That said, Dr. El-Erian provides a very good overview of the current state of the financial markets as of early 2008 and overall direction in the future.

Dr. El-Erian's background includes a doctorate in economics from Oxford, long service on the IMF, followed by a transition to the private sector, first at Salomon Smith Barney, then as CEO for the Harvard University endowment, and currently as CEO at PIMCO. The major themes he sees in the current financial situation include the following.

The Mortgage Mess

Over the last decades, mortgage originators (primarily banks and S&Ls) have moved away from issuing mortgages for their own long-term investment portfolio. Instead, they have written mortgages to capture the loan origination fees and then sold the mortgages for inclusion in packages that were marketed to other investors. The logic of this "securitization" process was that by pooling many mortgages in a single package, the risk of any one mortgage holder defaulting on a loan would be greatly reduced. In the process, the mortgage originators shifted their focus from the borrowers' long-term credit worthiness to the short-term.

In tandem with the shift in focus to the short term, the extensive use of derivatives, especially credit swaps, designed to mitigate the risk of default, tended to obfuscate the true risk in a securitized package of mortgages. The result was that many investors were lulled into the belief that their mortgage investments were low in risk when they really had no clear idea of how to evaluate the risk in a pool of mortgages and the associated derivatives.

These patterns lead me, a non-specialist, to suspect that any effective resolution of the mortgage mess must include either a shift back toward mortgage writers holding the loans for their own long-term investment or some other means of increasing the long-term financial responsibility of the originators for the loans they have approved.

Emerging Markets

As recently as 1998 financial crisis, the emerging markets as a group were subject to dramatic inflows and outflows of capital that dwarfed their domestic savings and investments. Their overall economic performance was also highly dependent on exports, dwarfing domestic demand and consumption. This situation has changed. Many of the emerging markets have emerged in several respects. The largest and most advanced (Brazil, Russia, India, China, Mexico, South Africa) are characterized by significant domestic demand and consumption that are able to at least partially sustain their economies even when the developed world's demand for their exports decreases. They generate significant domestic savings and investment, both private and public, the latter often in the form of Sovereign Wealth Funds (see below).

Many of these newly emerged markets (Russia and China may be the exceptions) are also less burdened by the demographics of an aging work force, suggesting that they may be better positioned to continue their growth over the coming decades than many of the industrialized nations.

Sovereign Wealth Funds

Sovereign Wealth Funds (SWFs) originated in the oil producing states (Kuwait, Abu Dhabi, Norway, Alaska) and some of the early developers in Southeast Asia (Singapore). The SWFs hold oil royalties or earnings from foreign trade in long-term investment funds to spread the benefits of the cash inflows into future years for future generations. To date, they have tended to be very conservative investors, placing most of their capital in short- to medium-term debt instruments of the governments of the industrialized world, especially the US.

In a way, this situation presents a potential role reversal between the emerging markets and industrialized nations. The industrial nations may now be subject to significant capital inflows and outflows controlled by the SWFs. As Dr El-Erian observes, the response of the industrialized nations to this role reversal should not be to institute controls on capital flows or other protectionist measures. These approaches would be self-defeating, hurting the industrialized nations more than the uncontrolled capital flows. Rather, the best prescription is the same one that the West advocated to the emerging markets in the past: Sound monetary and fiscal policies.

In the coming years, as the SWFs managers gain experience, expertise, and confidence, we can expect to see them change their focus from conservative short-term debt instruments to investments that offer higher long-term returns. This switch is likely to decrease the overall demand for government debt, increasing the interest rate on these instruments, and increase the demand for equities, driving up share prices.

Monetary Policy

Monetary policy has become harder to implement over the last 30 years. The money supply, once defined as currency in circulation plus demand deposits, has become almost impossible to define, let alone control. Once, only commercial banks could "create" money, concerting a dollar in deposits into several dollars by means of the reserve requirement ratio. Now, all manner of "shadow banks", hedge funds, private equity funds, investment banks, some domestic, some foreign, can use small amounts of equity capital to raise large amounts of debt capital, mimicking the prior role of the commercial banks. The difference is that these entities are not subject to the same regulations, such as reserve requirements, as commercial banks. We seem to be in the midst of a major evolution of the financial regulatory system in the US. The roles of the Fed, FDIC, Treasury, and other agencies will undoubtedly change. Let's hope that the changes are intelligence and for the better.

Reviewer's Comments

I found Dr. El-Erian's book both interesting and insightful and recommend it to readers looking for a broad overview of the current state of financial markets and their likely evolution in the future. Don't expect concrete investment advice; that wasn't his intent. (I suspect he saves such advice for his PIMCO clients.) My only criticism is that the style of writing is typical of many academic economists, somewhat convoluted and obtuse. The more complicated the concepts become, the simpler the sentences must be to convey them clearly. Still, I found the style a minor price to pay for what I think I gained.

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4.5 stars-Needs to clearly differentiate risk from uncertainty

The author of this book is clearly quite knowledgeable about the standard approach to risk management.He knows that it is badly flawed under conditions of herd behavior.Herd behavior occurs under conditions of Keynesian uncertainty(The decision maker DOES NOT know enough or have enough data that is reliable and non-conflicting to specify a unique distribution.The decision maker works with a set of different distributions and/or intervals.Keynesian or Ellsbergian revision can lead to a change in the underlying probability distribution being used as a best estimate of the data.This is completely different from the subjectivist Bayesian view upon which all risk management courses are based on) and/or Ellsbergian ambiguity.The standard risk (The decision maker DOES KNOW the particular probability distribution's population parameters and/or the sample statistics under conditions of risk.Bayesian updating/revision simply means that you continually revise/update the estimates of the mean and standard deviation of the SAME initially specified distribution through time)
management techniques, taught universally in all undergraduate and graduate classes in economics,econometrics,finance,business,and actuarial " science " worldwide, are completely unable to prepare the student for what can happen under uncertainty.For example,the author appears to correctly realize that herd behavior and cascades results from decision making patterns which are completely rational for the individual decision maker operating under conditions of uncertainty but make no sense whatsoever if operating under conditions of risk.Such behavior patterns appear to some authors in the socalled " new " field of behavioral finance to be the result of " irrational exuberance " .Keynes and Ellsberg knew better.Extensive discussions of risk and risk management are made throughout the book but no clearcut distinction appears anywhere in the book that clearly differentiates risk from uncertainty.
Another important analyst's perspective is missing .The missing analyst is Benoit Mandelbrot's distiction between the wild risk of the Cauchy distribution and the mild risk of the normal distribution.The mild risk of the Normal distribution is what risk managers mean by controlling/managing risk.Risk managers are completely helpless when faced with behavior patterns that generate the wild risk of the Cauchy distribution.The recently proposed 1-1.5 Trillion dollar bailout of Wall Street by President Bush,Ben Bernanke,and Treasury Secretary Paulson demonstates the complete and total intellectual bankruptcy of the standard approach to risk management
I recommend that the book be purchased because the author does make it clear that present analytic techniques for evaluating and choosing stock portfolios is flawed.It would have helped if he had been more specific about the nature of the flaws and how the work of Keynes,Ellsberg,and Mandelbrot,if implemented ,would have prevented this type of catastrophe from occurring or reoccurring in the future.

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Needs a good edit

El-Erian's publisher McGraw-Hill badly let down the author, and his readers, with a poor to nonexistent copy-edit. The book is full of jargon and poorly written paragraphs--to illustrate, here is a rather typical one-sentence paragraph: "The challenge of how to deal with consequential and volatile endogenous liquidity relates to another policy issue that I will discuss in Chapter 7: how to refine the traditional instruments of monetary control and ensure more meaningful and sophisticated supervision on a range of activities, with volatile leverage, that have been enabled by the ongoing structural transformations and yet are outside meaningful oversight."

This is technocratic obfuscation at its worst, and El-Erian, who is no lightweight, could have better been served by a heavier edit.

Perhaps the worst feature of the book is its attempt to reach three entirely different audiences--individual investors, policy-makers, and institutional investors. If you are an individual investor, realize that 75% of the book is written for others.

If you find your way through the jargon and infelicitous structure, some solid, thought-provoking ideas gleam in the darkness. Be prepared to dig, though, and bring your headlamp!

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reviews: 1, page 2, 3, 4, 5, 6, 7

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