In an earlier article, I explained that the protracted collapse of the UK government bond (or gilt) market on September 28, which followed the ill-fated “mini-budget” quarantine a few days earlier, now poses the problem of under-appreciation: UK pension schemes got dealing with massive changes in long-running gilt rates.
The market for gilts became very volatile a week after the mini budget. quote financial times,
The drastic changes in bond prices have puzzled analysts and investors. “The movements in long-term returns have been nothing short of incredible; The government bond market was in freefall,” said Daniela Russell, head of UK rate strategy at HSBC.
Markets crashed on the morning of Wednesday 28, when it became clear that most UK pension funds would not switch their liability-driven investment (LDI) strategies by the end of the day if the Bank of England did not step in. The bank temporarily suspended quantitative tightening and announced a £65 billion quantitative easing package to buy long-term government bonds and cut their rates. The gilded market rebounded strongly after the announcement, and by the end of the day, gilded government bond yields were below 4 percent.
“Had no action been taken today, government bond yields would have fallen from 4.5% to 7-8% this morning, in which case almost 90% of UK pension funds would have run out of collateral. [and become insolvent]”, says Karin Rosenberg, CEO of Cardano Investments. “They would have been wiped out.”
liability driven investing
So, what are LDIs and why are they important here? A standard explanation is as follows. The main obligation of a retirement plan is a cashless Annuity book that depreciates in value when interest rates rise and increases in value when interest rates fall. The fund then hedges its liability interest rate risk with a liquid interest rate swap (IRS).
When long-term interest rates rise, the plan loses on the swap side, but gains the same amount on the liability side. In theory, these should be offset to produce a zero net change in the present value of the plan. Although the fund hedges an illiquid exposure with a liquid, the latter is marked to market and margin is required to cover market value losses.
When interest rates rise, losses on the swap lead to margin calls, which the plan must meet by posting additional collateral (e.g., cash). under penalty of defaultIf too many businesses are affected, a scramble for cash could ensue that creates a death spiral in which interest rates are pushed higher and higher. The same happened on September 28.
However, this explanation doesn’t solve the problem – my UMayes project colleague Dean Buckner and I (and others) have been working on this for the past month and will report preliminary findings later this week (sneak preview: LDI The problem is bigger than it looks) – but enough for our purposes here. The key is how a rise in interest rates causes a margin call, which a settlement must meet by posting additional collateral under penalty of default.
The potential dangers of hedging an illiquid position with a liquid position are well known. The issue was welcomed by some as it applied to UK pension funds.
To add to this, there are at least three more concerns:
The first is that regulators don’t have much data on how large pension funds’ LDI holdings are or how large venture funds can be. Press reports suggested figures ranging from £1 trillion to £1.7 trillion for the latter, but all we really know is that it’s a larger number.
The second problem is leverage. Helen Thomas explains:
To take a simplified example, a pension fund buys £100 gilts and then sells them to a bank at a certain price with an agreement to buy them back within a year. (The collateral trades based on whether the gilded is rising or falling.) The fund takes £100 for its gilded and does it again: another £100 gilded, another repo transaction. and then. and then.
The third problem is that regulators have little data and no control over the size of any leverage.
Oddly enough, the Prudential Regulation Authority (PRA, part of the Bank of England) is the regulator used to be Seen the vulnerability of the pension fund years ago. As an insider recently wrote to me:
The big question is why not TPR [The Pensions Regulator] Or the PRA saw the risk of hedging an illiquid liability with a liquid asset. I remember there was some controversy about it in 2015, with executive level supervisors being blamed for raising this as an issue. “We should not impose even more regulations [burdens] on companies as much as they can afford”. [management’s revealing] answers.
Nevertheless, the issue managed to make its way to November 2018 from the bank financial sustainability report,
Fund managers who run pension fund liability-driven investment (LDI) programs report that they monitor the level of these pension funds’ liquid assets on a daily basis for potential collateral claims that may arise under stress. Although, It is not clear whether pension funds and insurers themselves pay sufficient attention to liquidity risksFor example, preparing work It was found by the bank employees Some insurers may not recognize all relevant liquidity risks(my emphasis)
Same financial stability report also reported the results of a stress test and concluded that “there was no major systemic vulnerability.” They are definitely wrong! Can’t say I’m surprised though. I’ve always maintained that regulatory stress tests were worse than useless because they provide false risk confidence – the analogy is that of a ship relying on a radar system to detect icebergs breaking through sea ice. Can’t find great hope.
In addition, having a stress test that a company fails creates unnecessary problems for regulators: the company will complain to senior management, who will reject the stress testers to resolve the issue. Hence the golden rule of stress testing for regulatory stress testers, an open secret of good practice in the regulatory community but almost unknown outside it: never test a company that will fail. I’ve yet to see a single instance where such tests have already correctly identified a critical vulnerability, but I’ve seen plenty of instances where they’ve overlooked vulnerabilities that led to spectacular disasters that were avoidable.
For example, American readers may remember the stress tests Joseph Stiglitz and his colleagues conducted for Fannie Mae in 2002. It models a highly adverse ten-year “nuclear winter” scenario for the US housing market and predicted that the probability of Fannie failing under this adverse scenario was essentially zero. Fannie and Freddie were only taken over by the government six years later to avert their failure, which cost American taxpayers hundreds of billions of dollars.
On returning to the UK, the bank realized there was a problem and wrongly concluded it was not a major systemic risk. because it didn’t want it to be, and never followed up. That systemic risk then came back to bite them at the worst possible time, as these things often do.
Things like this happen, but they happen a lot to UK financial regulators, and Governor Andrew Bailey himself has presided over a host of regulatory fiascos (see also here and here). To be fair, the bank is not responsible for the prudential supervision of pension funds. The regulator with specified responsibility for pension funds is “the” TPR, but it is common knowledge among those in the know that the TPR is even more ignorant than the other two main regulators, the PRA and the Financial Conduct Authority (FCA) and Inefficiency. There are veterans of FCA (whose previous CEO is one Andrew Bailey).
And you might be wondering, how did “the” TPR get messed up? Well, this prompted pensioners to tax LDI, mistakenly thinking that LDI offered a near-zero risk investment strategy that would help solve their deficit problems. The TPR then failed to collect much data on LDI positions, leaving UK regulators with insufficient data on them at a time when they needed it most.
So we have three regulators who might as well be Curly, Larry and Moe, and the insurmountable jurisdictional and coordination challenges they pose, regardless of which of those regulators is good, all confirming: again, UK financial regulation is not fit for purpose.