[yyy888sss]

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.

[smallnamespace]

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).

[lmm]

I read Levine's take but I'm not convinced. The accounting rules are like that because they reflect the real liabilities that the pension (eventually) has. Lower interest rates for a pension that needs to pay out a fixed amount in the future aren't just a "paper loss", they're a genuine asset deficiency.

This kind of swap wasn't just about protecting against the downside (otherwise they could've bought an option), it was about doing it as cheaply as possible by selling off the upside. They took on extra liabilities in order to pay as little as possible for their protection - or, equivalently, to boost their returns - and they missed, or failed to properly cover, an edge case in the liability they were taking on.

You can certainly make a case that it's well and good for pension providers to try to make as large a return as possible. But the "greed" shoe fits.

[runeks]

> [...] and they missed, or failed to properly cover, an edge case in the liability they were taking on.

What was this edge case? Rates rising quickly?

[lmm]

That and forgetting that even if their assets and liabilities balance in the long run, they can still get blown out on margin calls in the meantime.

[deepGem]

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]

The problem is you're getting margin called on your swap. You've got to put up more collateral, not when your liability comes due but now, and that probably means selling some assets for far less than they're worth.

[makomk]

Specifically, the problem is that a lot of these pension fund investments are in long-duration government gilts of a kind which are mostly useful to pension funds like them, and when the margin calls in and they had to sell there was not enough of a market for them and prices collapsed, which would have lead to more margin calls and prices collapsing until a substantial proportion of their investments had been transferred to bankers and speculators for much, much less than the actual value. Supposedly there were literally no bids for some of the gilts at some points.

I don't think there's much moral hazard in the Bank of England stepping in here; the duration structure of available gilts is a government creation anyway, a big reason no-one else wanted to touch them was because of uncertainty from the Bank's aggressive interest rate increases lately, and if government gilts aren't a safe, liquid investment we're all in deep trouble.

[lultimouomo]

When rates fall, liabilities increase, but so does the value of the bonds that the fund holds, so if they are properly funded and invest solely in bonds they are perfectly even.

But bonds have had very low yields for decades, which makes funding future pensions solely with them very expensive, so pension funds started investing in stocks- this makes sense, as pension funds are long term investors which can earmark funds as "not to be withdrawn for the next 30 years".

Now THIS creates the paper loss problem: yields fall, liabilities rise, but funds don't have enough bonds raising in value to match that loss. So they use derivatives to hedge the risk.

[djbebs]

No, the values of the bonds falls.

[lultimouomo]

When rates fall the value of outstanding bonds raises.

You can think about it this way:

Yesterday's bonds yield 10%.

Yesterday I bought a 10% yield bond brand new, at a 100 cents on the dollar.

Rates fall, today's bonds yield 1%. If you want to buy a bond, you can buy a new 1% yield one at 100 cents on the dollar, or you can buy my used one, which yields 10%. How is mine not more valuable than 1$?

[runeks]

> 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).

Honest question: why is the devaluation of bonds from a rise in the interest rate considered a risk to a pension fund? It doesn't impact the ability of the pension fund to fulfill its purpose: deliver an income stream to pensioners.

Sure, the market value of the bonds decrease when rates rise, but the bonds still provide exactly the same income stream as they did before.

[dereg]

That's a good question. Many companies want to get to as close to fully funded as possible so that they can offload the pension from their balance sheet and transfer the risk to an insurance company.

[xeromal]

Thanks for sharing this perspective.

[dereg]

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]

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."

[dereg]

Agree, I edited it out. I was so annoyed that I went too far with that statement. While they wouldn’t necessarily have been wiped out, they would have needed to make a LOT of calls.

[dchftcs]

On financial topics there are many emotions thrown around based on very little understanding. Unfortunately my upvotes to comments like this can only affect so little.

[briartoon]

Why do they need to hedge against rates falling? The value of a mixed portfolio of stocks and bonds will also move with changes in rates.

[growse]

> Why do they need to hedge against rates falling? The value of a mixed portfolio of stocks and bonds will also move with changes in rates.

Because the value of their present liability goes up more than the value of their bond assets, meaning they become more underfunded.

[mellosouls]

Why should you trust me on this? I've consulted pensions in the past.

To be fair, that may give you insight into the technicalities of the machinations, but with you having profited from and contributed to the financial system -that ordinary people have spent the past decade paying for the venality, stupidity and corruption of - that when you dismiss as corrosive with calls to mods to suppress counter-narratives, your investment doesn't necessarily mean we should trust you.

[collegeburner]

this isn't a "counter narrative" any more than "bill gates put microchips in my vaccine" is a "counter narrative". and i'm not being an asshole here, this is just a factual misstatement of LDI and what transactions are taking place. maybe the peak of the dunning-kruger curve shouldn't be sitting at the top of the thread for the first thing people read? i think asking @dang to at least pin a better explanation is fair.

[eru]

I mostly agree with your take on the facts. But I don't think you need to call for moderation quite so much. People are wrong on the internet all the time.

[collegeburner]

yeah true and i'm not asking for anyone to remove stuff, nothing wrong with being wrong (though i wish this person did it less confidently). when i commented though this was the top comment on the thread (still #2) and i was more hoping dang could pin a better explanation to the top. reading something egregiously wrong that's written very confidently first thing can screw up a thread imo.

[mellosouls]

I've upvoted you for wit and self-belief anyway.

[collegeburner]

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.

[sofixa]

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!!!"?) .

[cm2187]

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.

[anm89]

Way off course here

[obblekk]

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.

[dereg]

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.

[ColFrancis]

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]

They will go hungry, though. “Socialise the losses” means bailing out the banks, not the workers.

[xadhominemx]

Well it’s completely wrong

[Aunche]

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.

[jsmith99]

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).

[Scoundreller]

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]

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?