Failure to learn lessons of 2008 caused LDI pension blow-up
The crisis in Britain’s defined benefit pensions market last week was like a replay of the 2008 banking crisis — just with different acronyms. It was caused by a blow-up of LDIs — or liability-driven investment strategies, a vast £1.5tn corner of the financial markets that most people had never even heard of. Half a dozen lessons from 2008 have not been learnt.
1. There’s no such thing as risk-free. Aside from the three-letter shorthand, LDIs have at first glance little in common with the CDOs, or collateralised debt obligations, the financial instruments that spread the contagion of defaulting subprime mortgages a decade and a half ago. Pension funds were at risk, not banks. And the trigger was a price collapse in government bonds, not home loans. Yet there are clear parallels — most obviously, the AA-rated gilts that underpin LDI strategies were treated as risk-free, just like the AAA-rated CDOs that spiralled into near-worthless junk. Even if you accept that the credit risk on gilts is pretty minimal, the market risk in these normally ultra-liquid securities has been routinely underestimated.
2. Ultra-low interest rates have obscure side-effects. Years of low interest rates in the run-up to 2008 had encouraged a debt-fuelled “search for yield” that took investors into high-risk assets. The even lower rates that followed 2008 had a profound effect on DB pension funds. The gilts and bonds of these funds were not returning enough to match the schemes’ liabilities. LDI, based on borrowing (or “repo-ing”) against the collateral of low-yielding gilts, became an increasingly popular way for schemes to offset the shortfall. But what started as a hedge in some cases became a leveraged bet — an irresistible way to “juice” otherwise low returns.
This story originally appeared on: Financial Times - Author:Patrick Jenkins
