Sarah Breeden, the Bank of England’s director for financial stability, has had an interesting autumn. Earlier today she gave her first speech since the LDI shambles nearly blew up the UK’s financial system.
The title is timely: Risks from leverage: how did a small corner of the pensions industry threaten financial stability? The whole thing is worth reading for a pretty good explanation of the debacle, albeit one that describes the BoE’s role in a flattering light. We are all the principled heroes of our own stories, after all.
For those that need a refresher, the core problem was “poorly managed leverage”, according to Breeden. What was novel this time was that it cropped up in an obscure corner of the UK pension system, rather than in investment banks or hedge funds:
Many UK DB pension schemes have been in deficit, meaning their liabilities — their commitments to pay out to pensioners in the future — exceed the assets they hold. DB pension schemes invest in long-term bonds to hedge the interest rate and inflation risk that arises from these long-term liabilities. But that doesn’t help them to close their deficit. To do that, they invest in ‘growth assets’, such as equities, to get extra return to grow the value of their assets. An LDI strategy delivers this, using leveraged gilt funds to allow schemes both to maintain material hedges and to invest in growth assets. Of course that leverage needs to be well managed.
The rise in yields in late September — 130 basis points in the 30-year nominal yield in just a few days — caused a significant fall in the net asset value of these leveraged LDI funds, meaning their leverage increased significantly. And that created a need urgently to delever to prevent insolvency and to meet increasing margin calls.
The funds held liquidity buffers for this purpose. But as those liquidity buffers were exhausted, the funds needed either to sell gilts into an illiquid market or to ask their DB pension scheme investors to provide additional cash to rebalance the fund. Since persistently higher interest rates would in fact boost the funding position of DB pension schemes, they generally had the incentive to provide funds. But their resources could take time to mobilise.
To sever the feedback loop between gilt firesales to meet collateral calls and yields shooting higher and triggering a new round of margin calls, the BoE temporarily paused its plans to shrink its balance sheet and bought £19.3bn worth of gilts.
Breeden all but declares victory, estimating that LDI funds have now raised over £40bn, deleveraging “significantly”, and can now “withstand very much larger increases in yields than before, well in excess of the previously unprecedented move in gilt yields”.
One key point: Breeden reckons the flash point was primarily about £200bn worth of pooled LDI schemes — umbrella strategies that combine lots of smaller schemes — despite only making up a small part of the overall £1.4tn LDI industry.
The bigger LDI funds — typically large segregated mandates — contributed to the turmoil through their share size (they account for about 85-90 per cent of the market) but most were able to raise money from their individual pension plan clients.
In contrast, pooled LDI funds struggled, Breeden says:
In these funds, which make up around 10-15% of the LDI market, a pot of assets is managed for a large number of pension fund clients who have limited liability in the face of losses. The speed and scale of the moves in yields far outpaced the ability of the large number of pooled funds’ smaller investors to provide new funds who were typically given a week, in some cases two, to rebalance their positions. Limited liability also meant that these pooled fund investors might choose not to provide support. And so pooled LDI funds became forced sellers of gilts at a rate that would not have been absorbed in normal gilt trading conditions, never mind in the conditions that prevailed during the stressed period.
. . . Indeed the self-reinforcing spiral it led to meant that around £200 billion of pooled LDI funds threatened the £1.4 trillion traded gilt market, which itself acts as the foundation of the UK financial system, underlying around £2 trillion of lending to the real economy through wider credit markets.
Breeden also discusses broader topics including leverage, liquidity mismatches, counterparty risks, investor herding, why financial stability matters and how it can operate through several channels. For anyone who has had to read a GFSR (or even Kindleberger) there isn’t much new here.
But aside from an amusing claim that the UK was ahead of the game in addressing risks from non-bank leverage, the most interesting point Breeden made was that one aspect of the post-financial crisis regulatory architecture might sometimes actually make things worse.
Our emphasis in bold below:
This more widespread collateralisation of derivatives has been an essential part of the package of reforms to address faultlines exposed in the Global Financial Crisis. Initial margin requirements are vital to limit cascading counterparty credit risks . . .
But more widespread collateralisation has increased the sensitivity of liquid-asset demand to market volatility. And, if market participants are not prepared for such calls, their actions to raise cash can squeeze liquidity in already stressed markets, further amplifying shocks.
So whilst greatly reducing counterparty credit risks, with important systemic benefits, collateralisation may also increase systemic liquidity risks.