[PEN-L:27316] WCOM: Arrow at heart of economy

[Steve Diamond <sdiamond@xxxxxxx>]

www.ft.com
Published: June 26 2002 20:18 | Last Updated: June 26 2002 20:18

The equity bull market ended more than two years ago. But now it seems that
bull market psychology is unravelling fast.

The WorldCom accounting scandal is an arrow at the heart of one of the
standard bull market assumptions: that the US was the paragon of the world's
financial markets, with the most dynamic economy, the most innovative
companies and the highest accounting standards.

Overseas investors were happy to fund the US's substantial current account
deficit because they wanted to have a stake in the great US boom. But they
must now feel rather as emerging market investors did in the mid-1990s -
that they were suckers in a game rigged in favour of insiders.

In Asia, the blame fell on cronyism and a banking system that allowed
overinvestment in unprofitable projects; in the US, the blame is falling on
corporate executives, who have taken excessive risks and distorted accounts
in pursuit of lucrative share options.

The disillusionment with the US has spread to the dollar, which on Wednesday
slipped to within an ace of parity with the euro. It has also revived the
fortunes of gold, which moved back above $320 an ounce on the same day.
During the 1990s, gold seemed to have been supplanted by the dollar as the
safe asset of choice - but now investors are rediscovering the virtues of
the yellow metal.

Retail investors also seem to be losing faith in the cult of the equity that
they embraced so wholeheartedly in the 1990s. In the US and the UK,
investors seem once again to be looking to property as the most reliable
nest-egg; while in Europe, those investors who bought privatisations such as
France Telecom and Deutsche Telekom are sitting on heavy losses. A recent
survey by UBS Warburg found European retail investors were expecting equity
returns of just 6.7 per cent over the next 12 months.

Of course, it is possible that the current plunge in shares represents the
kind of climactic sell-off that often marks the bottom of a bear market.
Equity markets have drifted back to the lows last seen after September's
terrorist attacks on the US, which were followed by a rapid and substantial
recovery.

"We think the sell-off is very likely the bottom for the most recent
collapse in share prices this side of the Atlantic because the fall had
already been running out of steam. They say that the bottom is reached at
the darkest hour. The WorldCom event certainly counts as pretty damn dark
and, we feel, more than dark enough for us to ring the bell," say analysts
at UK stockbroker Charles Stanley.

But these are dangerous times, not least because of the way that the global
economy and financial system had adapted to the long bull market. There is
leverage built into the system, not as extreme as the gearing that brought
down Long-Term Capital Management, the US hedge fund, in 1998 but just as
dangerous for being so widespread.

That leverage shows up most obviously in the US corporate sector, where
companies that had geared up their balance sheets during the boom years are
now caught in the vice of falling revenues and the constant need to meet
interest payments.

But the leverage is all around. Life assurance companies, for example, buy
financial assets in order to keep their promises to pay out on death or on
the termination of policies. Regulators insist on resilience tests to ensure
that the insurers have sufficient assets to fulfil those promises. As equity
markets fall, these tests can force insurers to sell equities and buy less
volatile bonds.

That can force markets into a "death spiral" as falling prices oblige
insurers to sell equities, which pushes share prices down further, forcing
more sales of shares. To avoid this problem, the UK and Irish resilience
tests were relaxed after September 11.

But there are fears that the recent falls in markets have revived the
problem. There has been talk this month that European insurance companies
have been forced sellers of equities while last week UK bank Abbey National
paid £150m ($225m) to bolster the finances of its life assurance arm,
Scottish Mutual.

UK insurance companies were quick to say on Wednesday that they would not be
forced to sell equities and buy bonds because of the WorldCom news. But
there are fears that the crunch point may not be far below current market
levels.

General insurers also represent a source of leverage for the system.
Traditionally, they have lost money on their underwriting operations - money
they have made up through investment returns. But as those returns have
fallen, insurers have been forced to push up premiums, increasing the costs
of the corporate sector.

Furthermore, insurance companies form a significant proportion of the stock
market: as worries about their finances increase, their share prices
decline, putting further downward pressure on the market. The same problem
applies to banks, which have exposure to falling markets via their trading
activities and which have also seen a decline in their income from corporate
finance activities such as mergers and acquisitions.

The fortunes of the banks and insurance companies may be tied together in
another way. Banks have made much of their ability to avoid bad debt
problems by securitising debt - converting it into tradable form, which they
can sell on to outside investors. But the risks have been dissipated, not
eliminated. Someone will lose out from Enron and WorldCom and many suspect
the insurance industry will be the fall guy. The full damage may yet be
revealed.

Then there is the pension industry. Companies that have promised
final-salary-based pensions are dependent on stock market returns to meet
their promises. In effect, they have written a put option on the stock
market. As markets fall, they may be forced to put in more cash, thereby
reducing profits.

None of these risks, by themselves, may be enough to cause disaster. But the
past decade in Japan has shown what can happen if equity markets fall far
enough to weaken the position of the financial sector.

The loss of confidence in US assets, if sustained, also has some significant
economic implications. The US needs an inflow of more than $1bn a day to
fund its current account deficit. In a way, the US has also been making a
leveraged bet: borrowing money from abroad in the belief that it can invest
that capital at a high return.

If investors are unwilling to fund that deficit by buying US assets at
current prices, one of three things may occur: the US will have to cut back
sharply its spending on imports, hitting world trade; the Federal Reserve
will have to raise interest rates to attract foreign deposits, slowing the
US economy; or the dollar will have to fall far enough for US assets to look
attractive once more. That would pile deflationary pressures on to Europe
and Asia.

The worst may not happen, however. It is quite easy to picture a scenario
where most of the above problems disappear. If the global economy continues
to recover, corporate profits will steadily recover. That may restore
investor confidence in US equities and may cause them to dismiss Enron and
WorldCom as the inevitable catastrophes that emerge at the end of a bull
market.

Equity markets may then recover, releasing the pressure on insurance
companies. The leverage in the system could then work in the market's
favour, allowing investors to switch from bonds to equities.

But even a recovery will not leave the markets or the economy unchanged.
Regulators are already moving to tighten control of the accounting and
investment banking sector. Companies will not operate in the same
freewheeling environment that they enjoyed in the 1990s. And it will be a
long while before investors regain the bullish spirit they had just
two-and-a-bit years ago.


Stephen F. Diamond
School of Law
Santa Clara University
sdiamond@xxxxxxx