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ZorbaTHut  2yr ago (text post)   35667 thread views

Culture War Roundup for the week of September 26, 2022

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Part 2….

The way to do that hedging is basically to get really long gilts in a leveraged way. If you have £29 of assets, you might invest them like this:

  1. £24 in gilts,

  2. £5 in stocks, and

  3. borrow another £24 and put that in gilts too. [5]

That way, if rates go down, the value of your portfolio goes up to match the increasing value of your liabilities. So you are hedged. You were short gilts, as an accounting matter, and you’ve solved that by borrowing money to buy more gilts. In practice, the way you have borrowed this money is probably not by actually getting a loan and buying gilts but by doing some sort of derivative (interest-rate swap, etc.) with a bank, where the bank pays you if rates go down and you pay the bank if rates go up. And you have posted some collateral with the bank, and as interest rates move up or down you post more or less collateral.

This all makes total sense, in its way. But notice that you now have borrowed short-term money to buy volatile financial assets. The thing that was so good about pension funds — their structural long-termism, the fact that you can’t have a run on a pension fund: You’ve ruined that! Now, if interest rates go up (gilts go down), your bank will call you up and say “you used our money to buy assets, and the assets went down, so you need to give us some money back.” And then you have to sell a bunch of your assets — the gilts and stocks that you own — to pay off those margin calls. Through the magic of derivatives you have transformed your safe boring long-term pension fund into a risky leveraged vehicle that could get blown up by market moves.

I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.

Anyway, as I said above, 30-year UK gilt rates were about 2.5% this summer. They got to nearly 5% this week, and were at about 3.9% at 9 a.m. New York time today. You can fill in the rest. Here are Loukia Gyftopoulou and Greg Ritchie at Bloomberg News:

Fund managers running billions for pension funds faced collateral calls on strategies meant to give them exposure to long-dated assets to help match obligations that can extend decades. The so-called liability-driven investment, or LDI, funds were forced to post more collateral after receiving margin calls when gilt prices collapsed.

The central bank stepped in Wednesday after the calls threatened to push the gilt market into a downward spiral. The BOE had been warned by investment banks and fund managers in recent days that the collateral requirements could trigger a gilt crash, according to a person familiar with the BOE’s deliberations before they stepped in.

“The BOE intervention was required to prevent a vicious cycle becoming even more dangerous for pension funds forced to sell their gilt exposures,” Calum Mackenzie, an investment partner at Aon, said after the BOE intervention. “The market’s swift and significant reaction underlined the big risk faced by pension funds who have had or who could have had their liability hedges reduced.”

Firms including BlackRock Inc., Legal & General Group Plc and Schroders Plc manage LDI funds on behalf of pension clients. The pension firms use them to match their liabilities with their assets, often using derivatives.

The size of the LDI market has exploded over the past decade. The amount of liabilities held by UK pension funds that have been hedged with LDI strategies has tripled in size to £1.5 trillion in the 10 years through 2020, according to the Investment Association. These trades are typically used by defined benefit pension schemes. ...

When yields fall the funds receive margin and when yields rise they typically have to post more collateral. After the spike in gilt yields on Friday and into this week, LDI fund managers were hit by margin calls from their investment banks.

LDI collateral buffers are partly set using historical data to build models based on the likely probability of gilt price movements, according to Shalin Bhagwan, head of pension advisory at DWS Group. The sudden recent surge in gilt yields “blew through the models and the collateral buffers,” he said.

And here is the Financial Times on the BOE’s intervention:

The bank stressed that it was not seeking to lower long-term government borrowing costs. Instead it wanted to buy time to prevent a vicious circle in which pension funds have to sell gilts immediately to meet demands for cash from their creditors. That process had put pension funds at risk of insolvency, because the mass sell-offs pushed down further the price of gilts held by funds as assets, requiring them to stump up even more cash. “At some point this morning I was worried this was the beginning of the end,” said a senior London-based banker, adding that at one point on Wednesday morning there were no buyers of long-dated UK gilts. “It was not quite a Lehman moment. But it got close.” …

“If there was no intervention today, gilt yields could have gone up to 7-8 per cent from 4.5 per cent this morning and in that situation around 90 per cent of UK pension funds would have run out of collateral,” said Kerrin Rosenberg, Cardano Investment chief executive. “They would have been wiped out.”

And FT Alphaville has two very good explainers of the LDI problem, one by Toby Nangle and another by Alex Scaggs and Louis Ashworth, which I have drawn on here. And here is Nangle’s prescient LDI explainer from July. Modern finance made UK pensions vulnerable to runs, and then there was a run on those pensions, and the Bank of England had to step in to buy gilts to save them, because that’s what happens in a bank run.

Problem with this analysis and I’m familiar with the pension fund accounting and this formula is it’s not a perfect representation of whether you will be able to pay your future liabilities. It’s a good way to estimate your funding levels.

Embedded in all this math is an equity risks premium. When equity risks premiums increase your future returns are higher. Long story short actually hedging out a made up formula for estimating funding made them take a hedging risks that isn’t perfect for telling you if you will actually fund your liabilities.

Hence it’s a dumb formula and they hedged something they probably didn’t need to hedge. Also it was hedging nominal rates when one benefit of current markets is a great deal of the change in nominal rates is a change in real rates which means when they roll their current bonds (assume they own a lot of corporate bonds of less duration) they will be getting higher returns on the asset side of the equation.

Thanks for that, this explains to me why the pension funds were threatened (and yeah, I have noticed that a lot of governments have been really tempted to dip into pension funds because 'well the money is just sitting there and if we invest it or use it for infrastructural funding then we'll magically both spend it and increase it').

Borrow money or cut taxes, not both, seems to be the message. I don't know why Truss and her new Chancellor couldn't foresee that would be a problem, so does this mean "oh dear" for the handling of the British economy for the near future?

Let me get this straight: Managers want to make equity returns with bond risks. Banks come up with a miracle product that promises just that. They both profit for a few years. Then of course it all goes tits up, and the state 'has no choice' but to bail them out again. They're not illiquid, they're stupid or reckless.

You could say the banks delivered exactly what they promised. Only there was a secret ingredient, the fool who magically takes the risk away from them for free.

That's not quite right. They're saying that bond yields temporarily rose due to illiquidity in the market and were expected to fall shortly, which they did. The Bank of England didn't transfer wealth to the pension fund. They acted as the lender of last resort to tide them over.

Now, if the increase in interest rates had been more permanent, the strategy could have actually failed to the point of insolvency without an actual wealth transfer. Buy that didn't happen.

If my friend acts as a lender of last resort every time I am in danger of getting margin called, that is a valuable service, worth money, even though no money needs to be transferred from his account to mine.

Illiquidity is a red herring, a euphemism for the fact that the yield of those gilts is lower than it should be, propped up by overleverage. Bond yields are rising everywhere. Which is a problem, since they've successfully "hedged" themselves against falling interest rates by making themselves vulnerable to rising interest rates through leverage. Now they're getting margin called, and the state has bought bonds above market rate to keep the charade going, rather than liquidate their positions to let the market find the true, higher, yield.

Sure, but in exchange for this additional risk, they make it dramatically cheaper to fund pensions. I think to make a principled policy argument against this sort of arrangement, one would have to claim that the NPV of stochastic future government bailouts is less than the NPV of making the pensions much cheaper to fund.

I think I want pension funds to be stodgy, conservative, no-fun, reliable old plodding donkeys, not flashy exciting high-risk high-yield racehorses. 'Way cheaper now' has to be paid for eventually, and it can go sideways just like this did.

That doesn’t exists in the real world of being “stodgy conservative”. Transferring money from today to the future is always going to have a lot of risks.

There’s no risks free way of transferring consumption today into consumption tomorrow. It involves some part of society investing surplus today into capital investments that are fruitful tomorrow.

You could say just buy government bonds. But if everyone does that then government bond yields go down (potentially even negative) and someone needs to a credible borrower today that will pay you your capital tomorrow when your pensioners want to consume.

The US government of course does this with social security but that even runs into issues of population pyramids and whether social security will give much real spending power when their are more retirees than young caregivers/workers.

How much should society be willing to pay for that preference? I don't think your opinion is able to graduate from irritable mental gesture to serious policy preference unless you have some inkling of the relative costs involved.

You mean it’s a legit government subvention of pension funds in the form of an unofficial put, and everyone knows but don’t say. So you agree the claims of illiquidity and 'no choice' are bunk, missing the forest for the trees.

I have a few objections:

Moral hazard: encourages risk-seeking behaviour, causing greater problems than anticipated, currency crisis etc. The best thing for them would be to flip for the money repeatedly, get the most out of that put.

Leakage: the most reckless banks and managers take a larger cut of the profits in good years, sucking up the subvention.

Lack of transparency/uncertainty: Taxpayers are unaware the subvention was in place until the crash. Since it’s an unofficial guarantee, Market participants can never be sure of the bailout, leading to uncertainty and malinvestment .

Unfairness: The simple and honest worker-investor who decided to accept the risk of equities for his pension, did everything right, saw through the lies of bankers, doesn't cause systemic risk, has a cheap pension fund. As a reward, he is outcompeted by this chimera of governement subventions and banks.

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