Financial markets have experienced substantial stress for over a year. The turmoil emanated from the bursting of the housing bubble, which led to substantial losses on mortgage loans and mortgage-related securities. In part because the mortgage-related securities are complex and in part because future rates of defaults on the individual mortgages underlying those securities are hard to predict, financial markets have had difficulty gauging the magnitude of the losses on the securities. That opacity, in turn, has made it difficult to evaluate the financial condition of the institutions holding them.
Those problems have contributed to a broader collapse in confidence, leading to a general pullback from all types of risky lending. Financial institutions have become increasingly unwilling to lend to one another, creating stress in the interbank market for short-term loans that became particularly severe over the past several weeks. The issuance of corporate debt plummeted in the third quarter, and the commercial paper market has also been hit hard. Bank lending, which has thus far remained relatively strong, will likely be severely curtailed by the difficulties that banks are facing in raising capital. The general collapse in confidence is reflected in significant increases in risk spreads (or the difference between the interest rates charged on risky assets and those on Treasury securities). For example, the spread between the interest rate on corporate bonds with the lowest risk (AAA-rated bonds) and the interest rate on Treasury securities has risen by more than a percentage point since the middle of last year.
In sum, recent developments in financial markets represent a severe credit crunch, which could have devastating effects on the U.S. and world economies. In response, the Congress recently enacted a financial rescue package that, among other things, creates the Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury is authorized to purchase, insure, hold, and sell a wide variety of financial instruments. The Congressional Budget Office (CBO) analyzed many aspects of that program in recent testimony before the House Budget Committee.
The turmoil in financial markets has affected many aspects of the economy, including pensions. The most direct effect on pensions is through the prices of financial assets such as corporate equities and bonds. The Standard & Poor’s 500 stock market index, for example, has fallen by more than 25 percent over the past year as the outlook for the economy and corporate profits has worsened.
Because the majority of pension assets are held in equities, drops in stock prices have had a significant adverse effect on pension plans. Data from the Federal Reserve suggest that the decline in the value of financial assets cost pension funds (private-sector and public-sector combined) roughly $1 trillion—almost 10 percent of their assets—from the second quarter of 2007 to the second quarter of 2008 (the latest period for which data are available), and there has been a significant further drop in asset prices since then.