Financial Markets and Institutions (2-downloads)

The Subprime Financial Crisis 

and the Monoline Insurers

One spillover from the subprime financial crisis was

a hit to the monoline insurers, with spillover effects in

the municipal bond market. Unfortunately for the

monoline insurers, they not only insured municipal

bonds, but also debt securities backed by subprime

mortgages. With rising defaults on these mortgages,

monoline insurers started to take big losses, resulting

in credit downgrades from their AAA status. This

weakened the value of their insurance guarantees,

not only on subprime securities but on municipal

securities as well. As the subprime crisis got into full

swing, the markets took the view that monoline insur-

ance was not worth much and so municipal bonds

began to trade at lower prices based solely on the

municipality’s credit rating. The result was that state

and local governments now found their interest costs

rising. They were hit by a double whammy from the

subprime financial crisis of higher borrowing costs

and lower tax revenues because of their state’s

weaker economies. The result was not only weaker

state and local finances, but cutbacks in spending for

roads, schools, and hospitals.

---

532

Part 6 The Financial Institutions Industry

A second factor contributing to the growth of pension plans is that people are liv-

ing longer and retiring younger. Again, in the rural setting, people often remained

productive well into their retirement years. Many companies in urban America, how-

ever, encourage older workers to retire. They are often earning high wages as a result

of seniority, yet may be less productive than younger workers. The result of this trend

toward younger retirement and longer lives is that the average person can expect

to spend more years in retirement. These years must be funded somehow, and the

pension plan is often the vehicle of choice.

Types of Pensions

Pension plans can be categorized in several ways. They may be defined-benefit or

defined-contribution plans, and they may be public or private.

Defined-Benefit Pension Plans

Under a defined-benefit plan, the plan sponsor promises the employees a spe-

cific benefit when they retire. The payout is usually determined with a formula that

uses the number of years worked and the employee’s final salary. For example, a pen-

sion benefit may be calculated by the following formula:

In this case, if a worker had been employed for 35 years and the average wages dur-

ing the last three years were $50,000, the annual pension benefit would be

The defined-benefit plan puts the burden on the employer to provide adequate

funds to ensure that the agreed payments can be made. External audits of pension

plans are required to determine whether sufficient funds have been contributed by

the company. If sufficient funds are set aside by the firm for this purpose, the plan

is fully funded. If more than enough funds are available, the plan is overfunded.

Often, insufficient funds are available and the fund is underfunded. For example,

if Jane Brown contributes $100 per year into her pension plan and the interest rate

is 10%, after 10 years, the contributions and their interest earnings would be worth

$1,753.

2

If the defined benefit on her pension plan is $1,753 or less after 10 years, the

plan is fully funded because her contributions and earnings will cover this payment

in full. But if the defined benefit is $2,000, the plan is underfunded because her

contributions and earnings do not cover this amount. Underfunding is most com-

mon when the employer fails to contribute adequately to the plan. Surprisingly, it

is not illegal for a firm to sponsor an underfunded plan.

Defined-Contribution Pension Plans

As the name implies, instead of defining what the pension plan will pay, defined-