Bubble, bubble default trouble
By John Plender Published: October 3 2002 20:15

The most damaging bubbles are those in which stock market exuberance is accompanied by lending euphoria. This was true of the 1920s and of the 1980s Japanese bubble.

What makes the combination so destructive is the pro-cyclical nature of credit expansion, which causes asset prices, incomes and profits to rise in a boom that feeds on itself. It then becomes viciously self-feeding in the downturn, courtesy of the regulators, since banks' capital adequacy requirements go up instead of down when credit quality deteriorates.

That logic might suggest that the US exuberance of the 1990s was unusually benign. The banks were not much involved in financing the bubble and appear well capitalised today. It is true billions of dollars were wasted in inefficient investment, as in Japan in the 1980s. But many economists argue that this cost was simply a by-product of beneficial recycling of capital from old industries to new.

The snag with this comfortable view is that, even if a banking crisis is avoided for now, the US and UK financial systems have more in common with Japan's than is generally recognised. And there are plenty of ominous pro-cyclical forces at work in insurance and pensions.

The problem in insurance is well known and needs little elaboration. Falling equity prices cause insurers' capital to shrink. The more heavily exposed sell equities and reinvest in bonds, so equities fall further and increase solvency pressures.

Less well understood is the problem in pension funds, where growing deficits pose a far greater economic threat than in previous bear markets. Because pension funds are legally separate from their sponsoring companies, and because their disclosure is so opaque, their difficulties are too easily overlooked.

In national accounts, the investments of defined benefit pension schemes are shown as assets of the personal sector. Yet the members do not own them. Their right is limited to the promise of a retirement income, underpinned by the fund's assets.

The economic reality is that the pension fund is a subsidiary of the company. The pension liabilities are similar to corporate debt, while the assets are cross-holdings in the rest of the corporate sector. On that basis the Anglo-American world is not unlike Japan, with its cat's cradle of cross-holdings. And for companies whose fund is larger than the stock market capitalisation, vulnerability to falling markets is hugely leveraged.

The problem in this bear market is that many actuaries have encouraged the mismatching of bond-like liabilities with equities, leaving the company's shareholders to shoulder the risk. And an element of pro-cyclicality has been introduced by flawed methodology.

At some of Britain's largest companies, the actuaries have been valuing pension liabilities at a rate reflecting the expected return on the fund's assets. They substitute their own view of the assets' value for the market's. This leads them to take credit for the assumed future outperformance of equities against bonds without allowing for risk.

Among the perverse outcomes is that a fund invested exclusively in equities has lower liabilities than an identical fund invested in bonds. And a higher equity allocation reduces the company contribution - but at the cost of turning the company into a highly leveraged hedge fund.

Similar forms of double counting - for that is what it boils down to - have taken place in the US. But actuarial hokum there has been compounded by accounting practice that permits companies to vary their disclosed pension costs by adjusting the expected rate of return on the investments.

According to UBS Warburg, 60 per cent of Standard & Poor's 500 companies assume a return on assets of 9-10 per cent; 20 per cent of companies more than 10 per cent. These look absurdly high, which may lead to a pro-cyclical downward adjustment in a bear market.

This is not, admittedly, the same as a systemic meltdown in banking. But it could lead to one. In the aftermath of the investment boom and stock market bubble, private-sector debt is high and shrinking personal wealth makes low interest rates less stimulatory. The risk of Japanese-style deflation is palpable.

The Federal Reserve has risked creating a house price bubble to encourage consumers to bail the economy out of this hole but consumers cannot borrow for ever. The corporate sector will have to take up the baton. Yet credit rating agencies are becoming sensitive to pension fund deficits. Companies are reducing funds' equity exposure to minimise risk. The worst-hit face higher pension costs, encouraging a focus on rebuilding balance sheets rather than investing.

If this financial pressure delays the corporate sector's recovery, deflation will become a reality, not a risk. The real value of corporate debt will then increase, causing credit quality in the banking system to deteriorate. So we may yet have a banking crisis. A benign bubble is a myth.