Why the debt bubble hasn't burst -- yet

By Jim Jubak

It's all over, right?

• The stock market downturn that began with a 9% drop on the Shanghai stock market on Feb. 27 is over.
• Worry about the possibility that other lenders could catch the disease that has put more than two dozen subprime mortgage lenders out of business is over.
• The frantic de-leveraging that slashed the price of everything from gold to New Zealand bonds as speculators sold assets to pay off the loans they'd used to buy them in the first place is over.

And we equity investors can just go back to our usual worries about slowing economic growth and whether the Federal Reserve will cut interest rates, right?

Absolutely wrong. At least in the long run.

We're in the midst of an already huge bubble in the debt markets that's going to get bigger before it finally deflates. That bubble is characterized by huge bets on risk in the markets for government notes, corporate bonds, home mortgages and the various synthetic derivatives based on those instruments. And it's likely to take years to deflate -- either gently or in one big pop.

As I've argued repeatedly in recent columns (linked in the "More from MSN Money" box, below), investors are going to have to figure out a way to make money in the financial markets with this sword of debt hanging over their heads for the next five to 10 years.

Look across the country

To understand why the bubble isn't over and why it will have such a long life, look not to Wall Street but to the thousands of state capitals, city halls, insurance companies and retirement funds around the world -- in short, anyone who is trying to manage money now for the huge increase in retirees that an aging world is about to witness. It's places like these that are providing the hot gases that will keep the debt bubble growing.

Trenton, the state capital of New Jersey, is typical of the global forces inflating the debt market bubble.

New Jersey's finances are a mess. Gov. Jon Corzine and the state Legislature are trying to close a $2 billion budget gap for the current year without adding to the state's whopping $30 billion debt. At the same time, Trenton faces a tax revolt by state property owners, who pay some of the highest local property taxes in the country. That has put tax relief on the agenda, no matter how hard-pressed the state is.

The pension gap

So who ya gonna call when you need a few billion? State workers. The state has offered its workers a new contract that would raise the retirement age to 60 from 55 and require that workers increase their contributions to the state pension fund and, for the first time, contribute to the cost of their medical coverage.

It's not clear that the state's workers will take the deal, especially because the proposal has focused even more attention on the horrifying state of the state's pension funds. According to Douglas Love, a member of the council that oversees the state pension fund's investments and the CEO of bond market research company Ryan Labs in New York, state pension funds show a $56 billion deficit. That's just a tad higher than the $18 billion deficit figure that the state included in the state's latest bond offering. The difference, according to Love, is that the benefits the state's workers have already earned actually come to $132 billion, but the state claims they add up to just $92 billion. Assets at the state pension fund, everybody agrees, are well short of either projection at just $75 billion.

For years, the state has used creative (but legal) accounting to close the pension gap. The state simply calculates pension liabilities using methods that minimize its obligations. That solution, however, looks like it's headed out the window when new rules, expected in the next year or two, force the state to adopt accounting methods like those used by banks and insurance companies.

Finagling a way out

That leaves financial engineering as the only possible way out of the mess. If New Jersey can increase the projected returns it will earn on its pension funds, the problem will, at least as far as the accountants are concerned, simply vanish.

Not every kind of high-yield product will work, however. Like all pension funds and insurance companies, the New Jersey state pension fund wants to match the maturity of the financial instruments it buys to the year when those liabilities come due. Since so many of these liabilities are decades off into the future, the ideal investments for the pension fund to buy are debt instruments that promise decades of cash flow.

What fits the bill? Mortgages and mortgage-backed securities come to mind.

But these high-yield, long-lived debt instruments can't be too risky. The state, like many pension funds, is limited by its own rules in its ability to take on risk. So it needs a mortgage-backed security that, for example, could be cut up into pieces, so the state could buy a piece with high return and low risk. It could also lay off part of the risk through the use of derivatives that insure against default.

The driving force

Multiply New Jersey's problem by the tens of thousands of state, local, national and corporate pension funds around the world all facing skyrocketing future liabilities, then add in insurance companies and other institutional investors also looking to generate cash flow to meet the demands of aging investors, and you'll get global bidding for debt instruments with the highest possible projected returns and acceptably low projected risk.

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