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https://www.parliamentlive.tv/Event/Index/eac3a006-5e0b-4312-b4db-ba9af7ef9a3b
More nonsense from the Bank
Sarah Breeden (Bank Of England Executive Director, Financial Stability Strategy And Risk) who has said this today:
Many UK DB pension schemes have been in deficit, meaning their liabilities – their commitments to pay out to pensioners in the future – exceed the assets they hold. DB pension schemes invest in long-term bonds to hedge the interest rate and inflation risk that arises from these long-term liabilities. But that doesn’t help them to close their deficit. To do that, they invest in ‘growth assets’, such as equities, to get extra return to grow the value of their assets. An LDI strategy delivers this, using leveraged gilt funds to allow schemes both to maintain material hedges and to invest in growth assets. Of course that leverage needs to be well managed.
She does not mention at all the risk to these funds from investing in risky assets (anywhere in the speech) and the part above would lead an outsider (like many pension fund trustees) to think that taking risk via leverage is a sensible thing to do.
To be fair, she adds
Leverage is of course not the only cause of systemic vulnerability in the non-bank system – as we have seen with liquidity mismatch driving run dynamics in money market funds (MMFs) and open-ended funds (OEFs) during the dash for cash. ] But it is important where any form of leverage is core to a non-bank’s business and trading strategy. Indeed what happened to LDI funds is just the latest example of poorly managed non-bank leverage throwing a large rock into the pool of financial stability. From Long Term Capital Management in 1998; to the 2007 run on the repo market; to hedge fund behaviour in the 2020 dash for cash; and the failure of Archegos in 2021.
Nice of her to set out where the Bank failed in one of its two core objectives! As for the other core objective, er …
The Liability Driven Investments Problem is Bigger than It Looks
I (Buckner) will be presenting on the subject of LDI and the ‘bigger than it looks’ problem on Nov 3, 2022 04:30 PM London, by Zoom.
If you would like to attend, please contact me here for the flyer, and the Zoom link.
“The September 28th collapse in the gilts market led the Bank of England to announce a £65bn programme to stabilise long-term interest rates and save UK pension schemes from defaulting on their Liability Driven Investment (LDI) positions by the end of that day. Schemes had experienced liquidity problems on their Interest Rate Swap positions, losses on which had triggered margin calls requiring them to sell assets.
“The affair has highlighted the danger of hedging illiquid positions with liquid ones. I shall argue, based on a model of the underlying interest rate transformation involved in LDI, that there is more to the issue than has yet been appreciated.”
So what’s going on then?
Another mystery. This report from PwC says that the total pension deficit has reduced as a result of rise in yields.
They say that their source is data from the Pension Protection Fund. But see the chart above which I have overlaid with my estimate of the price of a 2030 gilt. You see that the 2030 gilt value precisely tracks the PPF liability estimates.
Here is the mystery: why so, given that LDI exists, and that LDI immunises schemes from changes in the long gilt rate?
Note also that the PPF say “”Conventional and index-linked gilt yields are used to value liabilities. *We do not hold sufficient data* to capture the impact of any structural changes to asset allocations nor to accurately capture changes in any leveraged LDI portfolios.”
So what is the true position?
We are now getting the full story as to why LDI was not stress tested
See Henry Tapper’s excellent analysis here.
Ups and downs
The chart above simulates the price history of a 2% coupon 30 year gilt purchased at the beginning of January 2017 and held until now (18 October). As you clearly see, the price rose throughout 2019, 2020 and most of 2021, then abruptly collapses, with the decline accelerating towards the third quarter of 2022. As journalists live to say “gilt prices fall as yields rise”. Quite.
No comment for now. I will discuss the odd but significant blip in March 2020 in the next post.
What are the losses from LDI?
The coverage of the Liability Driven Investments affair has been highly polarized. On the one hand, there are those (mostly consultants) suggesting it is a storm in a tea cup, LDI working ‘as expected’, nothing to see here, move on.
On the other hand, actuaries like Richard Lund, speaking at the First Actuarial Conference about severely disrupted core gilt market functioning, excessive and sudden tightening of financing conditions for the real economy etc etc.
Someone should at least be answering questions. E.g. if there have been losses, how much are they? See the chart above. A long-dated bond (here 18 years) could easily have halved in value with a move in rates from 2% to 5%. Any scheme that sold at those levels will have incurred a massive loss, or so you would think. Clearers like Northern Trust reported being overwhelmed by a slew of margin calls during bond market turmoil, so we know that selling happened.
So who was selling? And how much was lost? “We should be told”.
Easily the worst media explanation of LDI yet
See BBC News at Ten, 12 October 2022, for easily the worst media explanation of LDI yet. The fun starts 7:10.
Presenter “So let’s turn to our business editor, Simon Jack, who’s the expert on all these things.
Jack:
8:00 “Investors want more interest to justify the extra risk”. Not really. A gilt is risk free because the nominal payment (coupon and principal) is risk free. What investors are demanding is compensation for the extra inflation implied by the market.
8:05 “The cost of borrowing shot up”. Gilts are an asset, not a liability, and don’t involve borrowing. Of course, arbitrage implies the cost of long-dated borrowing will go up commensurately, so perhaps we could forgive him.
8:20 “Some pension managers have used them as security to get ready cash now”. Argh. Pension schemes have bought them using borrowed money, using them as security for the borrowing. No cash, apart from the haircut (‘margin’).
8:25 “To be able to pay out on those pension promises” Argh again. The scheme assets, typically risk bonds or equities, enable the payout. And again, there is no cash apart from the margin (and margin doesn’t have to be cash, necessarily).
Jack’s Wikipedia entry says “Before entering journalism, Jack worked for a decade as a corporate and investment banker in London, New York City and Bermuda. He has said that he neither liked the work, nor showed much ability at it.” Fair enough.
Liability Driven Investment (at last)
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.