John Cochrane has an amusing post at the Grumpy Economist on the recent shenanigans operations at the Bank. See the diagram above taken from Sir Jon Cunliffe’s letter.
Cochrane notes that on the left hand side there is a gap between assets and liabilities, yet in the fourth bar there is a positive “capital” bar. “Accounting 101, assets = liabilities, including capital. I guess UK regulations operate differently”.
This is a little unfair. As one of his commenters points out, the ‘LDI fund’ is effectively a separate balance sheet owned by the pension fund, and the ‘capital’ is really margin posted with the lending bank. That is, the fund borrows e.g. £90m from the lender and contributes £10m of its own money in order to buy £100m of gilts. In principle it is no different from borrowing money, at an agreed loan to value, to buy a house.
Cochrane, like the rest of the media, mentions the word ‘leverage’ with out qualification, but caution required, because ‘leverage’ commonly signifies ‘market risk’, whereas if correctly executed LDI should involve no market risk so long as the bond sensitivity perfectly matches the sensitivity on the liability side. That is, if every £1 fall in the value of the gilts (assets) perfectly matches a £1 fall in the value of the pension liabilities, the net present value of the scheme remains unchanged. Hence, no market risk.
However, there is massive liquidity risk, for the scheme is now matching a highly illiquid liability with a highly liquid – and marked to market – asset, and that is what has caused the current problem. If the value of the gilts falls from £100m to £95m, then the lending bank, seeing that its effective ‘loan to value’ is now 100%, will demand further margin. Result, if yields rise, pension schemes are forced to liquidate assets, which is exactly what happened.
Cochrane is right, of course, that the Bank should have foreseen the problems that LDI would cause. Or rather (since it did identify the problem in 2018) it should have acted promptly to forestall it.
But there is a further underlying problem in all of this that I shall discuss in a later post.
Clue: if all of the fixed liability exposure is hedged by fixed rate assets acquired by borrowing, and setting liquidity risk aside, then the scheme has exchanged fixed rate exposure for floating rate. For the repo interest rate will be variable. If the ‘other assets’ on the left hand side are equities, then the scheme overall is receiving a variable rate on its assets, and paying a variable rate on its liabilities.
More later.