In an earlier article , I explained that the collapse in the long-dated UK government bond (or gilts) market on September 28 that followed the particular ill-fated Kwarteng “ small budget” of a few days previously had exposed a hitherto underappreciated problem: UK pension check schemes were massively subjected to changes in long-dated gilts rates.
The week after the small budget, the gilts market became very unsettled. To quote the Financial Times :
Massive shifts in bond prices were leaving analysts plus investors bewildered. “ The moves in long-end yields were nothing short of amazing; the gilt market was in freefall, ” said Daniela Russell, head of UNITED KINGDOM rates strategy at HSBC.
The marketplace then collapsed on the early morning of Wednesday 28, when it became clear that if the Bank of England did not get involved, most UK pension programs would default on their liability-driven investment (LDI) strategies exchange positions by the end of the day. The financial institution responded by temporarily hanging quantitative tightening and announced a £ 65 billion dollars quantitative easing package to buy long dated gilts plus bring their rates down. The gilts markets retrieved sharply after the announcement and by the end of the day, gilt yields fell back to under four percent.
“ If there was no treatment today, gilt yields might have gone up to 7– almost eight per cent from 4. 5% this morning and in that situation around 90 per cent of UK pension funds would have run out of collateral [and become insolvent], ” said Kerrin Rosenberg , Cardano Investment chief executive. “ They might have been wiped out. ”
So , what are LDIs and why are they significant here? A standard description goes as follows. A pension scheme’s main liability is an illiquid annuity book that will falls in value when interest rates rise and rises in value if interest rates fall. The scheme after that hedges its liability interest rate risk exposure with a liquid interest rate swap (IRS).
When there is a move up in long-term rates, the particular scheme will lose on the exchange side, but gain the same amount on the liability part. In theory, these should counter to produce a net zero change in the scheme’s present value. However , the scheme can be hedging an illiquid direct exposure with a liquid one, with the latter marked to market, and with a margin requirement to pay mark-to-market losses.
When interest rates rise, the losses on the swap induce margin calls, which the scheme must meet by posting additional collateral (e. gary the gadget guy., cash) on pain of default . In case a lot of firms are affected, there can then be a scramble for cash that makes a death spiral in which rates of interest are pushed to higher and higher levels. This is what happened on September 28.
This explanation does not quite get to the bottom from the issue, however— my Eumaeus Project colleague Dean Buckner and I (and others) have been working on it over the last month and can report preliminary findings later this week (sneak preview: the LDI problem is bigger than it looks)— but suffices for our reasons here. The key is the method by which a rise in interest rates sets off margin calls, which the scheme must meet simply by posting additional collateral on pain of default.
The potential dangers of hedging an illiquid position with a liquid one are very well known. What few got appreciated was the scale of the issue as it applied to UK pension funds.
To add to which, there are a minimum of three further concerns:
The first is that regulators don’t have much data on how large the pension funds’ LDI positions or how big the funds at risk might be. Press reports suggested statistics for the latter ranging from £ 1 trillion to £ 1 . 7 trillion yet all we really know would be that the number is a big one.
The second problem is leverage. Helen Thomas explains:
To take a simplified illustration, a pension fund buys £ 100 of gilts and then sells to a financial institution with an agreement to buy them back in a year at a specific price. (Collateral is due within the trade depending on whether gilts rise or fall. ) The account takes the £ a hundred it got for its gilts and does it again: another £ 100 of gilts, another repo transaction. Plus again. And again.
The third concern is that regulators have small data on the extent of any leverage and no regulates over it.
Curiously, Prudential Regulation Authority (PRA, a part of the Bank of England) regulators had spotted the pension fund vulnerability years prior to. As one insider recently wrote me:
The big question is why none the TPR [The Pensions Regulator] or the PRA discovered the risk of hedging an illiquid liability with a liquid asset. I remember some sort of row relating to this in 2015, where the functioning level supervisors got blamed for raising this being a problem. “ We should never impose more regulation [burdens] on the firms than they can withstand, ” was the [management’s revealing] response.
Even so, the issue managed to make its way onto the particular bank’s November 2018 Financial Stability Report :
Fund managers running monthly pension funds’ liability driven investment decision (LDI) programmes report everyday monitoring of the level of funding available held by these pension funds against the potential phone calls on collateral that could occur in a stress…. However , it is not clear whether or not pension funds and insurance companies pay sufficient attention on their own to liquidity risks . For example , preliminary work simply by Bank staff has found that some insurers may not be recognising fully all the relevant liquidity risks . (my emphasis)
The same Financial Stability Report also reported the results of a stress test and figured there appeared to be “ simply no major systemic vulnerability. ” They certainly got that incorrect! I can’t say that I am surprised, however. I have always maintained that regulatory stress testing were worse compared to useless simply because they offer false risk confidence— the analogy is of a ship relying on a radar system to detect icebergs that cannot detect big lumps of ice in the sea.
Also having a stress test that the firm fails causes unneeded hassles for the regulators themselves: the firm would complain to their senior management would you then come down on the stress testers to make the problem go away . Hence the golden rule associated with stress testing for regulatory stress testers, which is a secret of good practice in the regulatory community, but almost unknown outside it: can not ever do a stress check that a firm will fail. I have yet to see a single case where such a test correctly identified a key vulnerability in advance, but I have observed many instances in which they missed vulnerabilities that resulted in spectacular disasters that could are already avoided.
To provide just one example, American visitors might recall the stress tests that Joseph Stiglitz great colleagues carried out for Fannie Mae in 2002. These modelled a highly adverse 10 years long “ nuclear winter” scenario for the US housing business and predicted that the possibility of Fannie failing below this adverse scenario has been essentially zero. Fannie and Freddie were then taken into government ownership in order to avert their failure only six years later, in a cost to US people of hundreds of billions of bucks.
Returning to the united kingdom, the bank realized there was an issue, wrongly concluded that it did not pose a major systemic risk because it did not need it to be , and never followed up. That systemic risk then came back to chunk them at the worst achievable time, as these things usually do.
These types of things happen, but they happen a lot to UK financial regulators, and Governor Andrew Bailey himself has presided over a good number of regulating fiascos (see also here and here ). To be fair, the bank is just not responsible for the prudential regulation of pension funds. The particular regulator with designated responsibility for pension funds will be “ the” TPR, however it is well known among those in the know that TPR is even more naive than the other two main regulators, the PRA and the Financial Conduct Authority (FCA) and the incompetence of the FCA (whose previous CEO is one Andrew Bailey) is legendary.
And how did “ the” TPR screw up, you might ask? Well, it pushed pensions to load up on LDIs , incorrectly thinking that LDIs provided a virtually zero risk expense strategy that would help resolve their deficit problems. After that TPR failed to collect much data about LDI opportunities, as a result of which UK regulators had woefully inadequate data about them at the very period when they needed that information most.
Therefore , we have three regulators who else may as well be Ugly, Larry, and Mo, and the intractable jurisdictional and coordination challenges they pose, even though any of those regulators had been any good, all of which confirms, once again, that UK financial rules is not fit for purpose.