This time the bodies are going to be buried in a different place
In October, as the pound tanked against the dollar and yields on UK gilt-edged bonds soared following the government’s ill-advised ‘mini-budget’, the arcane terminology of the financial markets suddenly made an unwelcome appearance on the front pages of the non-financial press.
In the same way the Irish public became intimately aware of spreads and haircuts following the EU bailout in 2010 and in which Italians constantly live in the shadow of Lo Spread (the differential between the yield on 10-year Italian and German government bonds), so Brits suddenly became acquainted with the problem of UK pension funds having to sell ‘gilts’ and ‘liquid assets’ to fund margin calls on the floating legs of interest-rate swaps as collateral values fell. The appearance of technical market-speak in every-day life is the sure sign that something is very wrong.
The fallout from the UK’s dice with financial-market death is now starting to become clear. Without mentioning actual number (just billions..), a recent submission to the UK parliamentary work and pensions select committee detailed the huge sums lost as Lloyds Banking Group had to liquidate equity holdings in pension funds it managed to meet collateral calls on derivatives1 . The net losers are of course the pensioners and future-pensioners invested in the fund.
As investors in the UK took fright, so funds began to limit withdrawals to prevent further disorderly moves in markets. This was particularly the case in the property sector where there is always a mismatch between investors’ desire to withdraw money at short notice and the ability of the funds’ managers to liquidate property assets to meet redemptions. Schroders, Columbia Threadneedle, and Blackrock all gated their property funds in response to the UK crisis2 .
While the pound has recovered some of its value against the dollar and UK bond yields have fallen, news that private-equity manager Blackstone has capped outflows from its $125b real-estate investment fund suggests that the problem facing markets is not just a passing one. As detailed in a front-page FT article, the problems of high inflation and rising interest rates are now clearly a global phenomenon which have reached the private equity world of Blackstone3 .
The UK pension crisis in October was caused by liability-driven investment (LDI). in 2001, large British companies were required to post their pension deficits on their balance sheets. To limit these liabilities, companies started to look at LDI - matching pension liabilities, particularly those for defined-benefit pensions, with high-grade and low-risk assets like government bonds. The aim was to limit pension deficits as they appeared on the balance sheet.
The problem though has been that with zero or near-zero interest rates since 2008, bond yields have been too low to match pension liabilities. This funding gap was filled with debt (leverage) - the use of interest-rate swaps where the holder receives a fixed rate and pays a lower, shorter-dated floating rate that varies with the market. By gearing-up a fund several times using these swaps, the liabilities could be matched on paper.
Then came inflation. As bond yields rose and central banks began hiking policy rates, the payments on the floating legs of these swaps soared, hence the margin calls, asset liquidations and so on. The wise folk at pension funds looked as though they had simply taken a huge, leveraged bet on interest rates never going up again. Up until last year though, the whole global bond market was priced the same way, so clearly they were not alone.
This is therefore really a story of the long-term effect of interest rates which were too low by any historical standard and which forced professional investors to adapt their behaviour to meet their mandated fund goals.
As far as the blame game goes, the pension-fund managers may look stupid but they aren’t really to blame as they didn’t break any rules. That safe pension funds were this leveraged and therefore so vulnerable is a matter of horror, but in a sense the use of leverage was a rational response to a low rate environment where one had to make a much-higher return than was offered by the yield on the usual assets pension funds bought.
If anyone is to take the rap, arguably it should be central banks who kept their policy rates too low for too long and who, through extraordinary monetary policy (quantitative easing or QE), encouraged excessive risk-taking in financial markets for an incredibly extended period (2009-2021). While throwing shade at the Fed and chums is fun, the focus here is on analysing where the risks currently lie and what is likely to happen next.
In the US at least, banking reforms following the Lehman bankruptcy and the global financial crisis have left most banks, especially the globally-significant investment banks (G-Sib’s), far better capitalised. In addition, they are required to hold large amounts of reserves in the form of high-quality liquid assets (HQLA’s), which for practical purposes means US Treasury bills. Most importantly though, the Dodd-Frank legislation curtailed proprietary trading by banks as well as their ability to partner with hedge funds or private-equity companies. The naughty behaviour that brought down Lehman has since been happening elsewhere.
Risk has thus migrated from the sell-side (banks) to the buy-side (hedge funds, private equity, asset managers and pension funds). During this period therefore, the sort of risk-taking behaviour induced by an extended period of low interest rates and QE appears to have affected the non-banking financial sector rather than the banks, in the US and elsewhere.
This is why the October 2022 bailout of the UK’s bond market was to aid pension funds - back in 2008, it was the Royal Bank of Scotland which took the public’s money. Likewise, the first signs of real pressure in the property market are affecting funds such as Blackstone’s. While private equity appears to have billions in ‘dry powder’ ready to commit to market at lower valuations, one wonders how much of this might eventually get used to prop-up funding for what has been a decade-long merry-go-round of private equity firms tossing assets to one another at ever-higher valuations as though they were financialised dog-toys.
In Europe, the banking story is a different one to the US. While European banks are better capitalised than they were a decade ago, the structure of the lending market is different. At risk of generalising, roughly a third of US corporate debt is in the form of loans (on bank balance sheets) while two-thirds comprises listed securities (bonds). The reverse is true in Europe, where around two-thirds of corporate debt is on-balance sheet in the form of loans.
Over the past few years, the ECB has been funding roughly €6 trillion of bank repo (effectively the re-use of debt as collateral to raise cash), of which corporate and bank debt is used as collateral. Rising inflation and interest rates will clearly pressurise this market, and with global recession an increasingly likely outcome for 2023, one ought to expect the European banking sector to come under pressure as it did during the Eurozone crisis a decade ago. The overall vulnerability of the European banking sector can be seen by the large discounts to the accounting book value at which its listed equity trades.
In the same way the effect of government deficit financing (and central bank monetisation) had a lagged effect of 12-18 months in terms of inflation appearing in the world economy in 2021, so too will the effect of rapid interest-rate hikes have a delayed effect on the real economy of some 6 months or so. The Fed first hiked in March 2022, so that hike is only just starting to feed through to the real economy. The effects on financial assets is faster and is already starting to be felt - the gating of funds is just a symptom of this.
A near decade-and-a-half of zero rates and QE has clearly affected the topography of the investment landscape as well as investors’ mindsets during that same period. The emergence of inflation and the aggressive central-bank response, especially from the Fed, has totally up-ended the certainties of this period, not least the buy-the-dip mentality. The advent of a recession is clearly going to bring up a number of bodies, only most likely the real pain won’t necessarily appear in the same place it appeared last time around.
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Josephine Cumbo, Gilts crisis triggered Lloyds fire sale, Financial Times, 02/12/2022
Fund giants gate UK pension withdrawals on pension run, AIC.co.uk, 04/10/2022
Antione Gara and Sujeet Indap, Blackstone caps outflows from $125b property fund, Financial Times, 02/12/2022