12.1 Borrowing and lending problems in nancial intermediation

this would have implied that holdings of bonds and property should have made up

at least 35 per cent of assets. The result meant that the USS was heavily affected by

weakness in equity markets. Despite the large decit, the trustees decided not to raise

pension contributions in an attempt to return the fund to balance. They argued that there

was no immediate problem of insolvency since income from assets was sufcient to

meet current obligations. They chose to put their faith in a recovery of equity prices. Of

course, equity prices did rise sharply in the following year and by the end of March 2006,

the decit had been removed. Unfortunately, equity prices again turned downwards soon

after. The approach of the trustees caused some controversy and raised doubts about

the impact that problems with the USS would have on higher education.

For more information on this controversy see John Plender, ‘USS punt could undermine

UK universities’, Financial Times, May 2006 and subsequent correspondence defending

the USS position.

Thinking ahead, rms began to close dened benets (DB) schemes to new

employees and even in a few cases to change the scheme to a dened contribution

basis, even for existing employees (the shipping rm Maersk was the rst example,

in 2002). Once again, the credibility of long-term saving was damaged in the eyes of

the general public.

The advent of the Pension Protection Fund was of no comfort to contributors

to the pension schemes of rms who became insolvent between 2001 and 2005

and were subsequently discovered to have holes in their pension funds. Until now,

government has resisted all demands to provide assistance to workers left without

a pension in these cases.

A different case entirely, though one which also surfaced as a result of the stock

market slump in 2000–02, was the sale of endowment mortgages. Endowment mort-

gages were long-term loans taken out for the purpose of house purchase. However,

instead of making monthly payments consisting largely of interest with a little bit

of capital repayment, borrowers paid only the rate of interest. The sum borrowed

remained intact for the whole of the loan period. The plan was to repay the whole of

the mortgage at the end of the term using the proceeds from a ‘with-prots’ endow-

ment policy, timed to end at the same time as the mortgage loan. We saw in Chapter 4

that ‘with prots’ policies offer purchasers a guaranteed minimum plus an entitlement

to share in the company’s annual prots. This accrues as annual bonuses which are

paid with the guaranteed minimum on termination of the policy.

A report submitted by the Financial Services Authority (FSA) in November 2001

to the Economic Secretary to the Treasury outlining the agenda for strengthening

insurance regulation identied two issues related to endowment mortgages. The rst

was that prots (and bonuses) grow over time as a result of the rm’s increasing busi-

ness but also as a result of ination(in other words, the policy accumulates nominal

amounts). Historically, because the UK had experienced quite high rates of ination

during the 1970s and 1980s, insurance companies and their clients had become used

to bonuses growing at a rate which represented a double-digit rate of return year by

year. The size of policies (and the accompanying premiums) necessary to produce

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Chapter 12 • Financial market failure and nancial crises

the desired target amount (the size of the mortgage) had been calculated on that

basis. Indeed, in the early 1990s, savers who had taken out endowment mortgages

twenty-ve years earlier typically found that the endowment policy was worth about

twice the value of the mortgage when it matured.

But the past is not necessarily a good guide to the future. With low ination and

low interest rates (after 1995), rates of prot growth came down to around 6 to 7 per

cent per annum. By 2001 it was clear that many policies were not going to deliver

the target amount and many investors faced a serious shortfall in the funds they

would have available to pay off their mortgage. The situation was made worse by

the stock market decline in 2001–02 when some life companies earned zero prots.

A with-prots endowment policy maturing in late 2002 was worth only about two-

thirds of the amount paid on an identical policy in 1999. The consequence was that

many savers, in their late to middle age, expecting to pay off their mortgage before

retirement, found that after a lifetime of saving they were left with a fraction of the

debt still outstanding.

The second issue was the way in which companies calculated the annual bonus.

Although ‘based on’ prots, the connection was not simple; worse, the formulae were

not publicly available. Most companies operated a process of ‘smoothing’; that is,

they held back some of the prots in good years so that they could still pay a bonus

in bad years. This was a laudable attempt to reduce the amount of risk faced by

investors. But so long as the ‘rules’ followed by the rm were secret, it was obviously

open to abuse. The result was that long-term savings products acquired a bad reputa-

tion just at the time when demographic changes meant that the government needed

households to commit to more long-term saving.

It might be argued, of course, that nancial intermediaries should not be held

responsible for the uctuations in stock prices. Indeed, this was the position that they

adopted in the face of much public criticism. But the sensitive issue which lay at the

centre of all these problems (and the one that bothered Sandler) was the extent to

which people fully understood the products they were buying and the lengths to which

intermediaries went in order to point out the risks (or even perhaps to conceal them).

Many distressed holders of endowment mortgages claimed that they had no idea that

what the endowment policy was buying was an equity-based product which had all

the risks of investing in the stock market. Others claimed that they realised this but

the insurance company had emphasised the high rates of return which were bound

to accrue ‘in the long run’ by quoting the returns on policies maturing in the 1990s.

The response of the FSA to the mis-selling claims is dealt with in Section 13.2.4.

What all these cases illustrate is the importance of nancial knowledge and

education on the part of buyers. Unfortunately, the public tends to be less informed

than the sellers about the nature of many nancial products (another example of

asymmetric information). In these circumstances people are bound to make unsuit-

able choices. These will be worse, of course, if sellers try to exploit their information

advantage by deliberately selling unsuitable products. But the fact remains that bad

decisions, however they are made, could not be made if there was not asymmetry of

information in the rst place. We return in Chapter 13 to attempts by government

to protect savers from their ignorance.

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