In previous blog posts here and here, I criticized UK financial regulators for missing simple leverage and margin requirements in UK pension funds. To be clear, I don't criticize the people. The point is, if after 10 years of intense regulation, a group of really smart and dedicated people can't see plain old leverage, the whole project of regulating risks is broken. And it's not just the UK. The Fed bailed out money market funds in 2020. Again.
I insinuated the regulators were not paying attention. I was wrong. It turns out they were paying attention. Which makes the failure all the more stark.
In Friday's Wall Street Journal, Greg Ip writes
In 2018, the Bank of England investigated whether a big rise in interest rates would trigger a cascade of forced selling by bond investors, destabilizing the financial system. The answer was no,
That they did think about it, and they missed it anyway is even more damning for the regulate-risks project.
Part of the explanation:
even if long-term rates rose a full percentage point in a week, which had never happened in records going back to 1990.
In the days surrounding the British government’s tax-cut announcement on Sept. 23, yields on British government bonds, called gilts, gyrated as much as 1.27 points in a single day
This is part of the problem of regulation. Regulators test a single number, 1.00000 percent rise. But 1.27%? The world ends. Also it's fairly easy to make a strategy that is safe up to 1.0000 percent but blows up at 1.0001 percent.
“The speed and scale of the moves in gilt yields was unprecedented,” the bank explained in a letter to Parliament. The refrain sounded familiar: the stock market crash of 1987, the near-failure of hedge fund Long-Term Capital Management in 1998, and the housing and mortgage crisis of 2007-09 were all precipitated by financial prices moving violently, by magnitudes outside historical experience.
Isn't the point of regulation and stress testing to worry about "unprecedented" events? After all, one might trust markets to think about precedented events. And, as the rest of the paragraph points out, it does seem like we're getting 100 year floods every 2 or 3 years these days.
The regulators even thought about derivatives and margin. Kudos. They just got the answer wrong.
In its November, 2018 financial stability report, the Bank of England included a lengthy analysis of leverage at pension funds, hedge funds, insurance companies and other “nonbanks.” It was mostly concerned that margin calls could lead to forced sales of assets that the market couldn’t absorb without big price moves. It concluded any such selling would be small “as a proportion of the total demand on market liquidity,” even if rates rose a full percentage point in a single day or week, which “has never been experienced in 10-year sterling swap rates looking back to 1990. Even over a month, it would be a 1-in-1,000 event,” plenty of time for a relatively smooth adjustment, BOE wrote.
Is it cheeky to point out that climate risk to the financial system has never happened in 1000 years?
In part thanks to those benign assumptions, the notional value of LDIs soared from £400 billion in 2011 to £1.6 trillion, equivalent to $1.7 trillion, last year, a staggering sum. This indirectly put downward pressure on long-term interest rates, making investors’ expectation of low rates partly self-fulfilling. But as high inflation sent rates higher this year, the opposite happened. LDI positions began to lose money. The jump in yields following the tax-cut announcement triggered widespread margin calls and forced liquidation of positions. A strategy that had once amplified downward pressure on rates is now doing the opposite.
When regulators bless risk taking, that absolves market participants of a lot of due diligence. Like the FDA approving a pill. So regulatory blindness can make matters even worse.
Again, it's not the people, it's the system. Allowing massive leverage but trusting regulators to regulate risk is broken.
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A lesson in bond yields vs. bond prices for your MBA class.
Mike Johannes at Columbia sends a great trio of graphs:
This is the UK sovereign yield curve. Reading from the bottom, 28, 6, 2 months ago, and now. Looking at the long end, it rises from 1% to a bit over 3%. 3% long-term yields used to be considered very low. This is a disaster? Aha, at low yields, small rises in yield mean big declines in prices. Here are the prices:
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The price of nominal bonds has gone from 100 to 29!
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The price of indexed bonds went from 400 to 100.
Now time to say something nice: The UK government made out like a bandit here. I've been yelling for over a decade that the US should issue long term bonds, precisely to insure against interest rate rises. The UK did that. On a mark to market basis, bondholder loss=government gain. The UK locked in a lot of astoundingly low-interest borrowing. Pensions may be in trouble, but long term debt is great for governments. So long, that is, as the government doesn't turn around and bail out everyone to whom it sold long term debt!
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Update:
In the comments, SRP points to a great post by Streetwise Professor, AKA Craig Pirrong, who argues that derivatives margin was the central problem, not leverage. In his story, a typical pension fund has fixed long term liabilities, pensions. Rather than buy bonds, borrow against bonds, and invest in stocks, as I asserted, the typical fund just buys stocks and then a big receive-fixed pay-floating swap to cover its pension obligations. It's the same thing economically, but achieved via the swap contract. Now, interest rates rise, and the swap contract needs massive cash collateral. I hope I got this right.
The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. ...
On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.
And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.
But note here that the funds have to have substantial gilts to sell. So they're not entirely investing in equities and swapping the interest rates.
The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.
Throughout history human society has experienced external crises such as plague and natural disasters. Supposedly, our technology is so much better now that we can cope with a lot of crises. But we can't change human nature and know-it-all bureaucrats.
ReplyDelete2018 was four years and 1.2 trillion U.K. pounds ago. One would expect that circumstances would change under the quadrupling of invested capital in that corner of the financial market. Most of this change was driven by change in financial reporting standards (I.F.R.S. in the U.K., and G.A.A.P. in the U.S.). You don't mention it, but that is the underlying cause. There are four generic LDI strategies that a company with a defined benefit pension can follow. I listed these in an earlier comment on an earlier blog post on the same subject. The "Overlay" strategy in LDI is the one that utilizes derivatives and leverage to gin up pension fund returns.
ReplyDeleteOddly enough, while much is being made of this development, the 'crisis' has yet to be proven fatal. There haven't been the spectacular failures such as Lehman Bros. in 2008. It's more like a wobble than a full-blown melt down.
It might be useful to broaden the reading list. The WSJ is an o.k. news source, but its economics reporters are trying to cover too many bases at the same time to do the subject justice. The U.K. market advisory firms, and others such as Cambridge Associates provide better in depth analysis and commentary.
I recognize that the point of the blog post is to slam regulatory bodies and financial regulations in particular, rather than to provide a clinic study of LDI strategies and associated risks to the markets. Not everyone has perfect foresight.
2020 required a larger bailout than 2008. You might not realize it from your seat but the financial system was very close to a fatal margin call if the Fed didn't buy more than $1 Trillion of bonds in less than a week. The Fed then bought corporate bonds which never occurred in 2008. Now the Fed has more than $1 Trillion in unrealized losses, there is a structural $1 Trillion annual fiscal deficit, the US capital account is negative and inflation is far above target To say that we have not moved into more dangerous territory is being willfully blind.
DeleteSo the claim that regulating financial leverage does not work; is simply stating a fact at this point. To deny this fact is equivalent to being a flat earther.
My remarks above referred to "G.A.A.P." It should have referred "G.A.S.B.", the American body that sets general accounting standards in the U.S.
DeleteMy remarks pertained to the U.K. financial markets in September 2022. The reference to Lehman Bros. 2008 was simply to make the point that the decline in bond prices in the U.K. did not set off a crisis in the U.K. financial market, though it might have been a close shave at that.
DeleteYou make some astonishing claims. Do you have public-domain references that support your assertions?
One reading of your assertions, in toto, is that regulators are necessary and that their ability to create money is an essential element of the exercise of that regulatory power. Another reading of your remarks is that financial markets are incapable of managing on their own. This reading compels ever greater regulatory oversight even unto the regulation of who can participate in capital markets and which markets they can access. For a right-libertarian, that view might well be anathema to her life-philosophy.
The US government could never term out their rates. They are not a price taker and their actions would have changed the price, their the biggest player by far.
ReplyDeleteAnd more long rate issuance would have canceled out QE. And hence canceled out a lot of stimulus. The private sector never had that sort of 30 year rate demand.
CATO Institute, Nov. 17, 2022: ESG and Financial Regulation.
ReplyDelete"An independent #FederalReserve is critical to the well-being of the US #economy. Having said that, it is getting harder to justify such independence when four big operational errors (of analysis, forecasts, actions and communication) are accompanied by a lack of accountability." -- Mohamed A. El-Erian (on Twitter).
ReplyDeleteOne is inclined to include the Bank of England in that ambit.
The Streetwise Professor begs to differ on the role of leverage in the British LDI turmoil.
ReplyDeletehttps://streetwiseprofessor.com/clearing-is-not-a-harmless-bunny-i-told-you-that-i-told-you-that-i-told-you-ad-infinitum-that-i-told-you-so/
John, I'd like to point out that I am not the source of the link to Craig Pirrong's blog page. "SRP" posted the link to "Streetwise Professor". His comment is no. 9 of 9 comments. My last comment was no. 8 of 9, and it referred to a quote from Mohamed A. El-Erian (on Twitter) that criticized the FRB's FOMC for policy failure.
ReplyDeleteThanks. And thanks for your many thoughtful comments here!
DeleteA paper authored by Lionel Martinelli and published by EDHEC Risk and Asset Management Research Centre during 2006, provides a stochastic model, based on Ito's Lemma, to optimize the isoelastic utility of returns of a pension plan fund in an asset-liability management environment. The author, in a specific example, finds the optimal portfolio allocation for a cost function comprising the CRRA utility function of the asset:liability rato of a three-asset portfolio comprising (a) the risk-free asset, (b) the standard mean-variance portfolio and (c) the liability hedging portfolio. "[T]he proportions invested in these two funds [(b) and (c)] are constant in time." The paper consists of 13 pages. Twenty-seven references are cited.
ReplyDelete"Managing Pension Assets: from Surplus Optimization to Liability-Driven Investment", EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE, March 2006. Lionel Martellini, PhD (U.C. Berkeley), Professor of Finance, EDHEC Business School, Scientific Director, EDHEC Risk and Asset Management Research Centre. The paper is accessible by navigating to
https://risk.edhec.edu/sites/risk/files/managing-pension-assets-surplus-optimization-liability-driven-investment.pdf
Abstract
"In this paper, we consider an intertemporal portfolio problem in the presence of liability constraints. Using the value of the liability portfolio as a natural numeraire, we find that the solution to this problem involves a three-fund separation theorem that provides formal justification to some recent so-called liability-driven investment solutions offered by several investment banks and asset management firms, which are based on investment in two underlying building blocks (in addition to the risk-free asset), the standard optimal growth portfolio and a liability hedging portfolio."
Justification:
"The aim of this paper is to provide an academic perspective on asset-liability management (ALM) strategies. In particular, we introduce a formal continuous-time model of intertemporal asset allocation decisions in the presence of liability constraints, and discuss how recent industry trends such as liability-driven investment fit with respect to the theoretical optimally designed strategies. The rest of the paper is organized as follows. In section 2, we provide a brief history of ALM techniques, outlining both the practitioner and the academic standpoints. In section 3, we introduce a formal model of asset-liability management. In section 4, we present a conclusion."
The ultimate paragraph in section 3 contains this observation which is germane to the U.K. pension fund asset sell-off in September, 2022:
"Note also that, as outlined in the previous sections, several investment banks have suggested using customized derivatives to perform liability-matching, and use leverage so that full amount of asset portfolio is still invested in a risky asset. This strategy corresponds to -100% in cash, 100% in the liability-hedging portfolio and 100% in the market portfolio, which can be rationalized under a specific choice of the risk aversion coefficient. More risk-averse investors, on the other hand, will prefer solutions involving less or no leverage."
Long time reader first time poster; inspired to move into UK LDI given your early work on structural term premium in sovereign bonds - your US sovereign conclusions are replicable to UK bonds.
DeleteYou are exactly right to suggest: ‘[pension schemes] buy bonds, borrow against bonds, and invest in stocks’. This has become the predominant strategy in the UK LDI market with schemes managing solvency interest rate (and inflation) risk while still being able to allocate to growth assets. Borrowing is predominantly provided by household named UK and US investment banks via gilt repo contracts. At the isolated LDI level, schemes agree to pay a cash rate in exchange for return on the gilts and collateralise these positions daily. The banks were ultimately at risk from pension scheme / LDI pooled fund default if the BoE had not stepped in. In this scenario banks are the forced seller of gilts and a bank run could have ensued.
At an overall scheme level the bonds (including those on repo) are usually less than or equal to scheme assets so the leverage risk is minimised if schemes can get assets to their LDI managers sufficiently quickly. Some schemes/LDI Managers were well setup for this eventuality, others weren’t and the later therefore started the self reinforcing gilt selling.
The pain points on bond prices of a shift to a high inflation environment were well known from your work but unfortunately ignored by a subset of those LDI managers who let their leverage levels drift up to unsafe levels and have given a bad name to US…
The finance regularity is totally fail, Taxes are high in the UK , Is there any permanent solution for this critical situation?
ReplyDelete