The collapse in the long-dated UK government bond (or gilts) market on 28 September 2022 that followed the ill-fated Kwarteng ‘mini-budget’ exposed a previously under-appreciated problem: UK pension schemes were massively exposed to changes in long-dated gilts rates.
The week after the mini budget, the gilts market became very unsettled. To quote the Financial Times, huge shifts in bond prices were leaving analysts and investors bewildered. “The moves in long-end yields were nothing short of incredible; the gilt market was in freefall,” said Daniela Russell, head of UK rates strategy at HSBC.
The market then collapsed on the morning of Wednesday 28 September, when it became clear that if the Bank of England didn’t intervene, most UK pension plans would default on their Liability-Driven Investment (LDI) strategies and swap positions by the end of the day. The Bank responded by temporarily suspending Quantitative Tightening and announced a £65 billion Quantitative Easing (QE) package to buy long-dated gilts and bring their rates down. The gilts markets recovered sharply after the announcement and by the end of the day, gilt yields fell back to under 4%.
“If there was no intervention today, gilt yields could have gone up to 7-8% from 4.5% this morning and in that situation around 90% of UK pension funds would have run out of collateral [and become insolvent],” said Kerrin Rosenberg, Cardano Investment chief executive. “They would have been wiped out.”
Liability Driven Investments
So, what are LDIs and why are they significant here? A standard explanation goes as follows: a pension scheme’s main liability is an illiquid annuity book that falls in value if interest rates rise and rises in value if interest rates fall. The scheme then hedges its liability interest rate risk exposure with a liquid interest rate swap (IRS). When there’s a move upwards in long-term rates, the scheme will lose on the swap side, but gain an equal amount on the liability side. In theory, these should offset to produce a net zero change in the scheme’s present value. However, the scheme is hedging an illiquid exposure with a liquid one, with the latter marked to market, and with a margin requirement to cover mark-to-market losses. When interest rates rise, the losses on the swap trigger margin calls, which the scheme must meet by posting additional collateral (e.g. cash) on pain of default. If a lot of firms are affected, there can then be a scramble for cash that creates a death spiral where interest rates are pushed to higher and higher levels. This is what happened on 28 September.
This explanation doesn’t quite get to the bottom of the issue. For those with the time and interest, I'd encourage you to watch a presentation for the Shareholders Association UK by my colleague Dean Buckner. In brief, the key is the way in which a rise in interest rates triggers margin calls, which a scheme must meet by posting additional collateral on pain of default.
The potential dangers of hedging an illiquid position with a liquid one are well known. What few hadn't appreciated was the scale of the issue as it applied to UK pension funds.
To add to which, there are at least three further concerns:
The first is that regulators don’t have much data on how large the pension funds’ LDI positions are or how large the funds at risk might be. Press reports suggested figures for the latter ranging from £1 trillion to £1.7 trillion, but all we really know is that the number is a big one.
The second issue is leverage. Helen Thomas from the Financial Times explains:
“To take a simplified example, a pension fund buys £100 of gilts and then sells to a bank with an agreement to buy them back in a year at a specified price. (Collateral is due on the trade depending on whether gilts rise or fall.) The fund takes the £100 it got for its gilts and does it again: another £100 of gilts, another repo transaction. And again. And again.”
The third issue is that regulators have little data on the extent of any leverage and no controls over it. Curiously, Prudential Regulation Authority (PRA, a part of the Bank of England) regulators had spotted the pension fund vulnerability years before. As one insider recently wrote me:
“The big question is why neither the TPR (The Pensions Regulator) or the PRA spotted the risk of hedging an illiquid liability with a liquid asset. I remember some sort of row about this in 2015, where the working level supervisors got blamed for raising this as a problem. “We mustn’t impose more regulation [burdens] on the firms than they can withstand,” was the [management’s revealing] response.”
Even so, the issue managed to make its way onto the Bank’s November 2018 Financial Stability Report:
“... fund managers running pension funds’ [LDI] programmes report daily monitoring of the level of liquid assets held by these pension funds against the potential calls on collateral that could arise in a stress. … However, it is not clear whether pension funds and insurers pay sufficient attention themselves to liquidity risks. For example, initial work by Bank staff has found that some insurers may not be recognising fully all the relevant liquidity risks.”
The same Financial Stability Report also reported the results of a stress test and concluded that there appeared to be “no major systemic vulnerability.” I’ve always maintained that regulatory stress tests were worse than useless because they offer false risk confidence – the analogy is of a ship relying on a radar system to detect icebergs that can’t detect big lumps of ice in the sea.
Also, having a stress test that a firm fails causes unnecessary hassles for the regulators themselves: the firm would complain to their senior management who would then come down on the stress testers to make the problem go away. Hence the Golden Rule of Stress Testing for Regulatory Stress Testers, which is an open secret of good practice in the regulatory community, but almost unknown outside it: don’t ever do a stress test that a firm will fail. I’ve yet to see a single case where such a test correctly identified a key vulnerability in advance, but I’ve seen many instances where they missed vulnerabilities that led to spectacular disasters that could’ve been avoided.
To give just one example, American readers might recall the stress tests that Joseph Stiglitz and his colleagues carried out for Fannie Mae in 2002. These modelled a highly adverse decade long ‘nuclear winter’ scenario for the U.S. housing market and predicted that the probability of Fannie failing under this adverse scenario was essentially zero. Fannie and Freddie were then taken into government ownership to avert their failure only six years later, at a cost to U.S. taxpayers of hundreds of billions of dollars.
Returning to the UK, the Bank realised there was a problem, wrongly concluded that it did not pose a major systemic risk because it did not 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.
These sorts of things happen, but they happen a lot to UK financial regulators and Governor Bailey himself has presided over a good number of regulatory fiascos. To be fair, the Bank is not responsible for the prudential regulation of pension funds. The regulator with designated responsibility for pension funds is ‘the’ TPR, but it’s well known among those in the know that TPR is even more clueless than the other two main regulators, the PRA and the Financial Conduct Authority (FCA) and the incompetence of the FCA is legendary. And how did ‘the’ TPR mess up, you might ask? Well, it pushed pensions to load up on LDIs, incorrectly thinking that LDIs offered a virtually zero risk investment strategy that would help solve their deficit problems. Then TPR failed to collect much data about LDI positions, as a result of which UK regulators had woefully inadequate data about them at the very time when they needed that data most.
So, we have three regulators who may as well be Curly, Larry and Mo, and the intractable jurisdictional and coordination challenges they pose, even if any of those regulators were any good, all of which confirms, again, that UK financial regulation is not fit for purpose