The Bank of England’s LDI autopsy
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.
This story originally appeared on: Financial Times - Author:Robin Wigglesworth
