Leverage and LDI – will we ever learn?

It’s always the way. At the center of every financial crisis, the same culprit lurks. He was there when the sensible bourgeois of Amsterdam lost their minds over tulips in 1637; when Wall Street bankers went crazy for investment trusts in 1929; when blue-collar Americans got into condominiums in Florida in 2007. And, of course, he was recently in the UK, prompting managers of orphan defined-benefit pension funds to pool their money with similar funds , thus accessing low-risk to increase returns in a world of falling interest rates.

It’s true, I do anthropomorphism. The “he” devil, for whom we should have no sympathy, is actually an “it” devil, also known as a “lever”. Whenever financial markets go into full swing, we can be fairly certain that the accelerator is leverage. As that great popularizer of economics, JK Galbraith, said in his best-known book, The great crash 1929the wonder of the discovery of leverage “hit Wall Street with a force comparable to the invention of the wheel”.

So Wall Street in 1929 reacted as the financial markets always do – they took a good idea and pumped it up to absurdity; in this case, mainly through the investment fund vehicle. Not satisfied with inserting a little leverage into a trust by using fixed-rate debt to help spice up its equity returns, promoters of new trusts have grown accustomed to having them invest in each other. others. So much so that at the top were leveraged trusts whose only assets were other leveraged trusts, whose only assets were… well, you get the idea. Galbraith concluded: “It’s hard not to marvel at the imagination implicit in this gargantuan folly. If there is going to be madness, something can be said to have it on a heroic scale.

By contrast, any folly in the current pursuit of so-called passive investing (LDI) by small UK defined-benefit pension funds and their agents may seem small-scale and monotonous. Even so, it has scared the bosses of the Bank of England (BoE) enough to put in place a Treasury-backed support package whose maximum cost could be £ 65 billion, or around a third of the £190 billion to which the government’s borrowing requirement could apply. exercise – and beyond, who knows?

BoE bosses had – and still have – every reason to be upset. As panic spread through the UK government equity market, in two days at the end of September, 30-year gilt yields rose more than 35 basis points (where 100 points equals one percentage point), while that the largest rise on a previous day was 29 basis points in 2000.

This overwhelmed the BoE’s risk models. Sir Jon Cunliffe, the Bank’s deputy governor responsible for financial stability, told the House of Commons Treasury Committee that his stress test models assumed the largest near-instantaneous increase in yields would be 100 basis points. basis (one percentage point). So when the price crash caused the 30-year gilt intraday yield to widen 127 basis points on September 28, it was both wider than the annual range for stocks of that maturity in all Last 27 years and beyond except four models reach. Under such circumstances, with its night vision out of action and enemies who don’t know where, what can a central bank do but wade through with its flamboyant bailout plan?

But there is more than that. Quite naturally – and as subtly as possible – the BoE wants to blame the government and its uncosted, albeit widely touted, tax giveaways in its September 23 mini-budget.

In addition, regulatory confusion plays a role in the mess. It is unclear who regulates multi-party wrapped in LDI schemes whose value now, according to the BoE, exceeds £1billion. This is because over the years these programs have grown ad hoc to meet a need that plagues most defined benefit pension plans – that the value of their investments is not sufficient to cover their future obligations; to use the jargon, they are loss-making. LDI programs help fill this funding gap by the simple expedient of offering cheap debt raised with the collateral of golden equity. For an earmarked fund, debt then buys other low-risk (well, usually low-risk) gilts, leaving other capital free to go into higher-risk but theoretically more rewarding investments, such as stocks. , whose best returns will eventually close the deficit. At least, that’s the idea.

With interest rates at rock bottom, what could go wrong? To which the one-word answer is “leverage”. When things are going well, leverage gives generously. When things go wrong, it comes off viciously. As a result, the UK is currently experiencing a mini – hopefully just mini – version of the US sub-prime mortgage market crisis that threatened to destroy the global financial system in 2007-2008 and, in the process, has brings down Northern Rock’s own bank.

The subprime crisis began with the sensible proposition that pooling mortgages was a good way to reduce risk and therefore reduce the cost of debt. It made sense for households to pool their debt, which was then resold in the form of securities. In this way, interest charges have decreased because default risks have been diluted into a larger pool. As a result, the cost of running people’s homes has been reduced, leaving more money for other things. What applied to people’s homes also applied to credit card debt or student loans. Grouping them together and pouring them into titles was a great idea. It proved that financial products could do good.

Until, that is, human nature gets in the way; until the process begins to spiral out of control; until the propensity of all agents in any financial system to fuck the customer starts to crack. It was then that new securities were issued whose purpose was not to invest in mutualized debt but to invest in securities that invested in mutualized debt. Once again Galbraith’s “gargantuan madness” was upon the world as funds took advantage of leverage and sometimes did so again.

It remains unclear whether similar excesses will seep into the mess of liability-driven investing. However, the basic ingredients are there:

● A good idea at the core – the goal of matching cash flows from a fund’s assets with its future cash obligations, aided by a little cheap debt.

● Pooling – bringing together small pension funds so that they can access the cheaper debt available to larger funds.

● Naive clients – never underestimate how little fiduciaries know about what they are protecting. This universal truth also applies to pension funds.

● Agents with big commissions to earn and little to lose – that’s why they are always labeled “snake oil salesmen”.

● Regulatory Fuzz – PRA, FCA, TPR (or none of these), choose your acronym from the alphabetical soup of regulators to decide who should regulate what or who of the LDI players; the BoE does not seem certain.

Yet, we might have thought that after the dotcom bubble, after the subprime crisis, after the Covid crash in 2020, risk models might be a bit more risk sensitive; sensitive to the idea that extremes are not simply decided by the unrelated effects of repeatedly tossing a coin, that they feed on themselves in a self-reinforcing process and, like a tumor, grow exponentially. After all, the quants who write the programs know this very well. They know their power law distributions inside out, and they know the real risk is the one you can’t see because you don’t even know it.

In the case of liability-driven investing risks, there doesn’t even seem to be an excuse. The BoE had highlighted the need to monitor risks within LDI funds at the end of 2018. But if the activities of certain players fell through holes in the regulatory net, it would most likely be because the funds are mainly based outside the Kingdom. -United.

Furthermore, it is a truism that regulation lags behind any activity it seeks to regulate and, in the case of responsible investing as in much of the financial industry, the solutions can be counterproductive. Whenever money is at stake, parties will take excessive risks if they know that the distribution of rewards and losses is unequal, if they have more to gain than to lose. This is called “moral hazard” and it happens when the rules in place encourage people to behave badly. In a wealthy, risk-averse world, this is prevalent mainly because those who are likely to gain are few and can gain a lot, so they have an incentive to misbehave; meanwhile, those who bail them out are numerous and each pay only a small compensation, so they have little incentive to behave strictly. And since the subprime crisis, these rules of the game seem to apply to the financial markets almost as if this sector had become just another client of the modern welfare state.

Yet that could change instantly if limited liability were removed. If all parties to a transaction were liable for the full amount of losses accruing to them, it would be a wonderful focus; they would seriously consider the risks and benefits of any proposal. Of course, enforcing it is easier said than done, in part because going back always is.

Also, it could be counterproductive as it would stifle the incentive to innovate if failure most likely equates to financial annihilation. One side of the argument might say that this is a price worth paying, especially since, for example, it would be hard to argue that the world would be a poorer place without, for example , leveraged bonds (CDOs). Okay, but the plain vanilla CDO is surely a worthwhile security since it helps provide home ownership to blue-collar Americans. Similarly, the City of London would hardly be the financial power it remains – roughly – without the “Bill on London”, the banknotes that financed the commercial side of Britain’s global expansion. in the nineteenth century. As for the limited liability company – sure, it’s done some incredibly rich silly things over the past 20 or so years, which is deeply annoying – but without it the standard of living in the West would still, most likely, be in the 19th century.

All of this says that, whatever the outcome of the leveraged pension fund episode, the moral is that wherever there is a benefit, there is always a cost; that costs and benefits are inseparable; that those involved in deficit defined benefit funds have failed to consider the costs as well as the benefits of bringing them back to stability. It is only when this iron law of economic life is forgotten that trouble begins.