The Near Collapse of the UK Pension Sector Exposes Failures by Financial Regulators
In an earlier article, I explained that the collapse in the long-dated UK government bond (or gilts) market on September 28 that followed the ill-fated Kwarteng “mini budget” of a few days earlier had exposed a hitherto underappreciated 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, when it became clear that if the Bank of England did not intervene, most UK pension plans would default on their liability-driven investment (LDI) strategies swap positions by the end of the day. The bank responded by temporarily suspending quantitative tightening and announced a £65 billion quantitative easing 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 percent.
“If there was no intervention today, gilt yields could have gone up to 7–8 per cent from 4.5 percent this morning and in that situation around 90 per cent 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.”
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 is a move upward 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 spira
Article from Mises Wire