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ZorbaTHut  2yr ago (text post)   35663 thread views

Culture War Roundup for the week of September 26, 2022

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The weird pension fund insurance stuff was one of those classic things that nobody thinks will go wrong until it does (as I understand it, and I don’t, it was effectively a kind of leveraged insurance product designed not to improve returns but to stabilize them over decades, because obviously pension funds have to disburse funds when times are bad as well as good). Pension funds got margin called, and therefore had to suddenly sell long-dated gilts which crashed the market because there were fewer buyers than every pension fund unloading them simultaneously, so the BoE was forced to step in to stabilize the market. I don’t think it realistically counts as a full resumption of QE but obviously it is a hilarious setback.

The short version of what happened to the pension funds is:

  • Pension funds have future-dated liabilities. Falling interest rates raise the NPV of these liabilities, potentially causing the pension fund to become accounting-insolvent.

  • UK regulation makes it a bad idea to allow a pension fund to be accounting-insolvent, so pension funds want to manage this risk. The main way they do this is using long-dated interest rate swaps. Effectively this is a side bet on interest rates - if interest rates fall, you win enough on the swap to cover the increased liability.

  • Market interest rates rose, fast. This meant that pension funds lost money on the swaps, and faced margin calls which needed to be paid in cash in the very short term (days, not weeks). But the offsetting gain from a falling NPV of liabilities is a purely paper gain. So pension funds were in danger of becoming cash-insolvent.

  • In addition, rising interest rates reduce the value of long-dated government bonds, which are a popular form of collateral. The 50-year gilt was briefly trading at 40p in the £ (not because anyone was afraid of a default, just because the interest rate suddenly became below-market). If you were using this gilt as collateral, you would be facing a margin call even if you hadn't lost money.

Whatever you call it, the BoE was forced to print money to cover government (planned) deficits that the bond market couldn't bear. This is bad.

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