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Heres what happened: The Bank of England (BoE) suppressed interest rates for 2 decades, driving government bonds from 6% to 2%. Pension funds typically had a hi

Heres what happened: The Bank of England (BoE) suppressed interest rates for 2 decades, driving government bonds from 6% to 2%. Pension funds typically had a high percentage of bonds, so they decided to borrow money (again, made artificially cheap by the BoE) to buy 2-3x the amount of bonds on leverage to be able to pay out the same as one 6% bond. Now the BoE is slowly raising rates to 'fight' the inflation it created over the past 20 years, which is causing these house of cards pension funds to start to tremble. The fund directors are relaxed though as have already paid themselves large bonuses every year, and after 2008 they realised they could rely on the government to come in and socialise the loses stemming from their financial recklessness.

obblekk 4y ago
This is actually the clearest, simplest explanation I’ve read (including Matt Levine’s). I think this is the first time moral hazard made sense to me from an operational perspective. The fund manager who in old days would feel bad about risking retirees money, now legitimately feels okay knowing there’s no way they’ll go hungry. Unfortunately there’s no easy way out of this.
- ColFrancis 4y ago
  Sure, punish the recklessness to remove the moral hazard. You can both make sure people don't starve and align the incentives. If you don't then next time it will be worse.
- nopenopenopeno 4y ago
  They will go hungry, though. “Socialise the losses” means bailing out the banks, not the workers.
- xadhominemx 4y ago
  Well it’s completely wrong
- dereg 4y ago
  It’s a completely incorrect explanation. There’s no moral hazard here, they weren’t risking pension or funds through the swap agreement. The reason why the answer isn’t clear is because pension math is boring. The thing is, you can’t fully grasp the truth unless you’re willing to engage in it.
smallnamespace 4y ago
No, this explanation is not correct. These pensions were generally not trying to juice yield by buying gilts with leverage (they would not be able to borrow cheaply enough to make this work, and leverage would be better used to buy stocks). The margin calls are coming from interest rate swaps they did to mitigate accounting risk on their long term liabilities. When rates fall, pensions take huge paper losses because the present value of liabilities moves inversely with interest rates. To hedge this risk, you enter into a swap with a bank to essentially pay current floating interest rates (in return for receiving a fixed rate). This swap's value moves in the opposite direction of the liabilities. Unfortunately because rates moved up so quickly, these swap trades are deep in the red. Even so, the funds should not be going bankrupt from these trades, because the losses net against enormous accounting gains from their liabilities being worth less. Anyway, this is a complicated and technical story about the interaction between bond math, accounting, and liquidity risk. There is a lot to criticize, but the moralizing version of 'greedy pension fund managers borrowed to juice yields' is not quite accurate, and Matt Levine's article is a good source (although he doesn't get into the nitty gritty of interest rate swaps).
- xeromal 4y ago
  Thanks for sharing this perspective.
- deepGem 4y ago
  When rates fall, pensions take huge paper losses because the present value of liabilities moves inversely with interest rates Lets say my liabilities are 1000 at interest rate 10 Now interest rate is 5 so my liabilities value is 2000 Now I don't look good, so what do I do. I buy a swap ( which I equate to a put option) which is valued at 100 on the basis of my liability being at 2000 If my liability drops to 1000, the swap goes to 200 (thereby I'm screwed) Now the interest rate is 20 So my liability is 500 and the swap is at 400. I am really screwed. However, my liabilities are also proportionally down, so I am basically at break even. Is this the correct math ? If so, then there shouldn't be any reason to panic.
  - lmm 4y ago
Aunche 4y ago
So if this interpretation is correct, what should the fund directors have done instead? If you can only get 2% safely, but you need 6% or else the pension becomes insolvent, you're going to have to take some risks. UK stocks have been stagnant overall and plummeted during the pandemic, so that's not a much better option.
- Scoundreller 4y ago
  Usually pension fund solvency calculations are based on returns being related to the long bond interest rate, so as the long term bond rate goes up, your liabilities decrease.
  - Aunche 4y ago
    Your liabilities only decrease in the interest exceeds the payouts, but I doubt that's happening even as they're raising interest rates. What are they supposed to do in the meantime? Pray for the central bank to raise interest rates while your liabilities accrue?
- jsmith99 4y ago
  UK defined benefit pension fund trustees have been quite risk averse actually. The main purpose of these investments was to avoid a mismatch between the funds assets and its liabilities (which can fluctuate wildly as actuaries make small changes to their assumptions). Their actual investment strategy is often very risk averse though, heavy on bonds and on buying insurance. Any deficit has to be covered by the original employers but trustees don't seem to have taken the temptation to chase returns. A recent report from the regulator showed most funds with deficits has less than 40% of funds in what they called 'return seeking assets' (ie things like shares as opposed to boring (usually!) things like public sector bonds).
collegeburner 4y ago
uhhhhhhh what? it says pretty clearly this is interest rate derivatives (makes sense). i think what you're trying to talk about is repo leverage: buy a bond, repo it out, use cash to buy another bond and repo it ad infinitum until counterparty risk measures start blinking. remember a repo is me selling you my bond at a haircut and buying it back later for a little more, so basically a secured loan. the repo margin (the amount more than the loan value i have to give you as a premium) depends on creditworthiness and bond prices blah blah blah but the gist is there's some margin where, if the value of the collateral i gave you (the bonds) falls too much (like now) you margin call me and say "give me more stuff because your collateral lost too much value". this is what happened to the pension funds: they buy bonds (safe asset), sell via repo (cheap loan to invest in interest rate swaps for hedging) and now they get margin called because the "safe" gilt just shit the bed. some are using gilts as collateral for swaps, so their collateral fell so much that their hedges are getting called. now think about if you've leveraged the repo market to double or triple up on bonds, whatever your counterparties will put up with... you don't have to cover the fall in the gilt, you have to cover 2-3x (or more) the fall. so it's not really "borrowing to buy more" because that wouldn't make sense it's diluting your collateral in a way that tbh counterparties should account for better. same thing happens in real estate if you do it right. the big concern here is a death spiral: funds have to sell gilts, value of gilt drops more, more funds have to sell gilts. BOE doesn't want this so it's now back to QE because the exchequer is a bozo.
dereg 4y ago
This is demonstrably untrue and yet you proffer it as fact. The pensions benefit from rates rising, because higher rates decrease their liabilities more than it decrements the value of their bonds. The pensions have, as a result, entered swap positions go hedge themselves against rates falling. The only issue is that the sudden drop in the gilt has created a feedback loop in the gilt sell off. There is a reason why explanations of what went on are so complicated… It’s because pension math is extremely boring. However, you cannot understand the situation, even intuitively, without going into the nitty-gritty to try to learn the plumbing. Your mistruth is incredibly corrosive to discussion on this site. @dang please keep an eye out. Edit: I’m reading through the comments here and virtually everyone has it wrong. The pensions made what should have been a good decision to hedge their liabilities. They made a bad decision in terms of forecasting their liquidity needs in a high-stress rate scenario. Don't look at the word "margin call" and assume they did something wrong. Simplistically, if you're getting called on a hedge, you're probably making money, just less of it. On a position like this, the fund faces a "margin call" every day. It's called variation margin, and all that means is the position's PNL is settled on a cash basis, daily. You may be thinking of a margin call in terms of a retail investor naked shorting a stock that has subsequently tripled in value. It's nothing like that. Variation margin "calls" are part of the structure of the instrument. I've consulted pensions. Saying that pension fund managers did this to "pay themself large bonuses" is laughable – pension fund managers aren't compensated like other areas of finance so the incentive is always to be more risk averse because they want to keep their jobs. Edit edit: I don’t mean to say these pension mgrs don’t deserve criticism. It’s just that what I see is so off mark.
- ctchocula 4y ago
  I agree with the spirit of this post, but I think you are going a bit too far in the other direction by stating that "the pensions would have been fine without the policy". From Matt Levine's article today, it was a more dangerous situation than you are making it out to be: > "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."
anm89 4y ago
Way off course here
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cm2187 4y ago
No it's not about the level of interest rate, it's about the duration. I think they go long/short a short term and long term bond, creating some duration exposure to manage the discount risk of their pension liabilities. You can't really create the arbitrage you are describing. Whatever the gilt yields is pretty much what you would pay to borrow against it.
sofixa 4y ago
The rest of your comment has already been discussed, but this part: > Now the BoE is slowly raising rates to 'fight' the inflation it created over the past 20 years Is wrong. Inflation is the result of a pandemic and policies to combat it's results, and a war impacting critical raw materials. It is not a purely monetary phenomenon like so many people prefer to pretend (I never got why - is it a "I have been saying these policies will result in inflation for 20 years, and I was right!!!"?) .
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obblekk 4y ago

This is actually the clearest, simplest explanation I’ve read (including Matt Levine’s). I think this is the first time moral hazard made sense to me from an operational perspective. The fund manager who in old days would feel bad about risking retirees money, now legitimately feels okay knowing there’s no way they’ll go hungry. Unfortunately there’s no easy way out of this.

ColFrancis 4y ago
Sure, punish the recklessness to remove the moral hazard. You can both make sure people don't starve and align the incentives. If you don't then next time it will be worse.
nopenopenopeno 4y ago
They will go hungry, though. “Socialise the losses” means bailing out the banks, not the workers.
xadhominemx 4y ago
Well it’s completely wrong
dereg 4y ago
It’s a completely incorrect explanation. There’s no moral hazard here, they weren’t risking pension or funds through the swap agreement. The reason why the answer isn’t clear is because pension math is boring. The thing is, you can’t fully grasp the truth unless you’re willing to engage in it.

smallnamespace 4y ago

No, this explanation is not correct. These pensions were generally not trying to juice yield by buying gilts with leverage (they would not be able to borrow cheaply enough to make this work, and leverage would be better used to buy stocks). The margin calls are coming from interest rate swaps they did to mitigate accounting risk on their long term liabilities. When rates fall, pensions take huge paper losses because the present value of liabilities moves inversely with interest rates. To hedge this risk, you enter into a swap with a bank to essentially pay current floating interest rates (in return for receiving a fixed rate). This swap's value moves in the opposite direction of the liabilities. Unfortunately because rates moved up so quickly, these swap trades are deep in the red. Even so, the funds should not be going bankrupt from these trades, because the losses net against enormous accounting gains from their liabilities being worth less. Anyway, this is a complicated and technical story about the interaction between bond math, accounting, and liquidity risk. There is a lot to criticize, but the moralizing version of 'greedy pension fund managers borrowed to juice yields' is not quite accurate, and Matt Levine's article is a good source (although he doesn't get into the nitty gritty of interest rate swaps).

xeromal 4y ago
Thanks for sharing this perspective.
deepGem 4y ago
When rates fall, pensions take huge paper losses because the present value of liabilities moves inversely with interest rates Lets say my liabilities are 1000 at interest rate 10 Now interest rate is 5 so my liabilities value is 2000 Now I don't look good, so what do I do. I buy a swap ( which I equate to a put option) which is valued at 100 on the basis of my liability being at 2000 If my liability drops to 1000, the swap goes to 200 (thereby I'm screwed) Now the interest rate is 20 So my liability is 500 and the swap is at 400. I am really screwed. However, my liabilities are also proportionally down, so I am basically at break even. Is this the correct math ? If so, then there shouldn't be any reason to panic.
- lmm 4y ago

Aunche 4y ago

So if this interpretation is correct, what should the fund directors have done instead? If you can only get 2% safely, but you need 6% or else the pension becomes insolvent, you're going to have to take some risks. UK stocks have been stagnant overall and plummeted during the pandemic, so that's not a much better option.

Scoundreller 4y ago
Usually pension fund solvency calculations are based on returns being related to the long bond interest rate, so as the long term bond rate goes up, your liabilities decrease.
- Aunche 4y ago
  Your liabilities only decrease in the interest exceeds the payouts, but I doubt that's happening even as they're raising interest rates. What are they supposed to do in the meantime? Pray for the central bank to raise interest rates while your liabilities accrue?
jsmith99 4y ago
UK defined benefit pension fund trustees have been quite risk averse actually. The main purpose of these investments was to avoid a mismatch between the funds assets and its liabilities (which can fluctuate wildly as actuaries make small changes to their assumptions). Their actual investment strategy is often very risk averse though, heavy on bonds and on buying insurance. Any deficit has to be covered by the original employers but trustees don't seem to have taken the temptation to chase returns. A recent report from the regulator showed most funds with deficits has less than 40% of funds in what they called 'return seeking assets' (ie things like shares as opposed to boring (usually!) things like public sector bonds).

collegeburner 4y ago

uhhhhhhh what? it says pretty clearly this is interest rate derivatives (makes sense). i think what you're trying to talk about is repo leverage: buy a bond, repo it out, use cash to buy another bond and repo it ad infinitum until counterparty risk measures start blinking. remember a repo is me selling you my bond at a haircut and buying it back later for a little more, so basically a secured loan. the repo margin (the amount more than the loan value i have to give you as a premium) depends on creditworthiness and bond prices blah blah blah but the gist is there's some margin where, if the value of the collateral i gave you (the bonds) falls too much (like now) you margin call me and say "give me more stuff because your collateral lost too much value". this is what happened to the pension funds: they buy bonds (safe asset), sell via repo (cheap loan to invest in interest rate swaps for hedging) and now they get margin called because the "safe" gilt just shit the bed. some are using gilts as collateral for swaps, so their collateral fell so much that their hedges are getting called. now think about if you've leveraged the repo market to double or triple up on bonds, whatever your counterparties will put up with... you don't have to cover the fall in the gilt, you have to cover 2-3x (or more) the fall. so it's not really "borrowing to buy more" because that wouldn't make sense it's diluting your collateral in a way that tbh counterparties should account for better. same thing happens in real estate if you do it right. the big concern here is a death spiral: funds have to sell gilts, value of gilt drops more, more funds have to sell gilts. BOE doesn't want this so it's now back to QE because the exchequer is a bozo.

dereg 4y ago

This is demonstrably untrue and yet you proffer it as fact. The pensions benefit from rates rising, because higher rates decrease their liabilities more than it decrements the value of their bonds. The pensions have, as a result, entered swap positions go hedge themselves against rates falling. The only issue is that the sudden drop in the gilt has created a feedback loop in the gilt sell off. There is a reason why explanations of what went on are so complicated… It’s because pension math is extremely boring. However, you cannot understand the situation, even intuitively, without going into the nitty-gritty to try to learn the plumbing. Your mistruth is incredibly corrosive to discussion on this site. @dang please keep an eye out. Edit: I’m reading through the comments here and virtually everyone has it wrong. The pensions made what should have been a good decision to hedge their liabilities. They made a bad decision in terms of forecasting their liquidity needs in a high-stress rate scenario. Don't look at the word "margin call" and assume they did something wrong. Simplistically, if you're getting called on a hedge, you're probably making money, just less of it. On a position like this, the fund faces a "margin call" every day. It's called variation margin, and all that means is the position's PNL is settled on a cash basis, daily. You may be thinking of a margin call in terms of a retail investor naked shorting a stock that has subsequently tripled in value. It's nothing like that. Variation margin "calls" are part of the structure of the instrument. I've consulted pensions. Saying that pension fund managers did this to "pay themself large bonuses" is laughable – pension fund managers aren't compensated like other areas of finance so the incentive is always to be more risk averse because they want to keep their jobs. Edit edit: I don’t mean to say these pension mgrs don’t deserve criticism. It’s just that what I see is so off mark.

ctchocula 4y ago
I agree with the spirit of this post, but I think you are going a bit too far in the other direction by stating that "the pensions would have been fine without the policy". From Matt Levine's article today, it was a more dangerous situation than you are making it out to be: > "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."

anm89 4y ago

Way off course here

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cm2187 4y ago

No it's not about the level of interest rate, it's about the duration. I think they go long/short a short term and long term bond, creating some duration exposure to manage the discount risk of their pension liabilities. You can't really create the arbitrage you are describing. Whatever the gilt yields is pretty much what you would pay to borrow against it.

sofixa 4y ago

The rest of your comment has already been discussed, but this part: > Now the BoE is slowly raising rates to 'fight' the inflation it created over the past 20 years Is wrong. Inflation is the result of a pandemic and policies to combat it's results, and a war impacting critical raw materials. It is not a purely monetary phenomenon like so many people prefer to pretend (I never got why - is it a "I have been saying these policies will result in inflation for 20 years, and I was right!!!"?) .

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