[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.