Bank Shareholders Face 'the Unthinkable': El-Erian

As the nation's largest banks continue to stand on shaky ground, it is the company's shareholders that bear the biggest risk, Pimco's Mohammed El-Erian said.

"The unthinkable is thinkable," the co-chairman of the bond fund management giant said on CNBC. "The equity holder is the most vulnerable in this economy because either they get diluted, or when the government comes in the government tries to protect the taxpayer, which means the government comes above the equity holder in the capital structure."

That means that in any type of government rescue plan for the banking system, the US taxpayer gets repaid before the shareholders collect returns or dividends.

Such a consideration is important as Citigroup's shares lose more than half their market value and a handful of other major institutions vie for government funds to boost their liquidity.

It all adds up to a treacherous investment environment in which even major institutions pose risk of seeing their credit evaluations drop to junk status.

"This is a problem of equity," El-Erian said. "The great risk is that the rating agencies may move, and if the ratings agencies move to downgrade the banks we are in a completely different world."

In this environment, investors are turning to bonds in historical levels, with prices of Treasury debt soaring and yields dropping to unprecedented lows.

"The bond market is telling you this is beyond a flight to quality, this is a flight to liquidity," El-Erian said. "There's damage to the system, and what you're seeing is a reaction to that and a reaction in the yield curve."

The most important things for the market now are a government that provides capital for the purchase of damaged assets, said El-Erian, who also called on President-elect Barack Obama to offer some assurances, particularly on what the direction to the Troubled Asset Relief Plan will take.

There's been considerable clamor for Obama to designate his Treasury chief, but he's been reluctant to make an announcement.

Last week's announcement from Treasury Secretary Henry Paulson that the government no longer would directly buy distressed assets but rather provide liquidity for institutions to do so rattled the markets.

"When are we going to get clarity on policy?" El-Erian said. "Suddenly the market isn't sure what the TARP was supposed to do, and clarity on that issue would help."

© 2009 CNBC.com