Perspectives on Risk - Sept. 30, 2002 (Short, quick follow-up)
A Primer on LDI AND Defined Benefit Pension Risk; Frances Coppola Suggests That The BOE Action Was To Support Banks; Brainard Reinforces “No Quick Pivot” Message; Watch the Loan Market
A Primer on LDI AND Defined Benefit Pension Risk
I love a good derivatives blowup. Cut my teeth on Bankers Trust leveraged derivatives with a few of you.
Matt Levine wrote a great primer on what happened1. Better than I could do. Here’s the TL;DR of the story:
Pensions have long-term liabilities
Rather than just defeasing with long-term Gilts, pension plans entered into receiver swaps, and invested the cash in riskier assets designed to grow.
Economically, they are hedged against rate movements
However, when rates rise the pension fund must post collateral to the counterparty; but they do not receive any cash from the liabilities, hence they must sell the other assets
Also, the liabilities and the swaps, though, have different accounting treatments. So while economically hedged, firms accounts may not reflect this reality, and this needs to be managed by the firms.
Here are two primers for those interested:
The big collateral call facing UK pension funds (Bloomberg)
PENSION FUNDS AND LIQUIDITY SPIRALS
Frances Coppola Suggests That The BOE Action Was To Support Dealer Banks
In a comment titled What was the real reason for the Bank of England's gilt market intervention? Ms. Coppola writes:
Why did the Bank of England intervene in the gilt market this week? The answer that has been doing the rounds is that it was protecting the solvency of pension funds. But this doesn't make sense to me. The Bank doesn't have any mandate to prevent pension funds going bust. And anyway, the type of pension fund that got into trouble isn't at meaningful risk of insolvency. There was never any risk to people's pensions.
I don't think the Bank was concerned about pension funds at all. I think it had a totally different type of financial institution in its sights.
She correctly maintains that:
scary stories about pension fund "insolvency" entirely missed the point. DB pension funds were never at risk of insolvency. They were merely extremely illiquid.
And concludes:
So this is not a story about pension funds, it's about banks. The gilt market freeze was creating a cash collateral shortfall for pension funds, and as a result banks were at risk of serious losses on derivatives.
I recommend those interested read her entire piece. I have found her to be quite knowledgeable about financial markets and central banking, and respect her thinking and opinion.
She may be correct, but I tend to disagree with her conclusion. In the Twittersphere, folks were making analogies to AIG’s failure, and I think these are a reach.
The dealer banks were likely hedged on their books, and in any case if their open positions were large enough to cause problems that would be a horrendous failure of risk management. Unlike AIG, the swaps were probably on standard ISDA documentation, and the collateral calls were to numerous, solvent institutions likely able to make the payments by selling unencumbered assets. The swaps may even be centrally cleared on LCH (not sure about this). The solvency of dealer financial institutions is much more robust; and we have not lived through six months of Bear, Lehman, Reserve Primary, etc. so there is less incentive for CB support.
What I suspect happened is that there is a feedback loop the threatened to trigger a fire-sale externality. As the swap positions moved more into-the-money for the dealers, they would need to hold less Gilts to hedge. In this way, the rise in UK rates threatened to cause selling that would further push up rates,
In addition, pension funds would face a first-mover advantage in liquidating their unencumbered collateral. Consistent with the BIS Logan/Hausar paper and Hausar speech we discussed in the last Perspectives2, I think this was more about insuring orderly market clearing than any particular counterparty.
But I may be wrong, and she may be right. We’ll see.
Brainard Reinforces “No Quick Pivot” Message
Global Financial Stability Considerations for Monetary Policy in a High-Inflation Environment
We are attentive to financial vulnerabilities that could be exacerbated by the advent of additional adverse shocks. For instance, in countries where sovereign or corporate debt levels are high, higher interest rates could increase debt-servicing burdens and concerns about debt sustainability, which could be exacerbated by currency depreciation. An increase in risk premiums could kick off deleveraging dynamics as financial intermediaries de-risk. And shallow liquidity in some markets could become an amplification channel in the event of further adverse shocks.
Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. For these reasons, we are committed to avoiding pulling back prematurely.
I read this as the Fed is willing to let some things break as long as they can manage the outcome through liquidity provision rather than outright cuts.
European Systemic Risk Board Issues Long-Winded Warning
WARNING OF THE EUROPEAN SYSTEMIC RISK BOARD
…the probability of tail-risk scenarios materialising has increased since the beginning of 2022 and has been exacerbated by recent geopolitical developments. … Three severe systemic risks to financial stability have been identified.
First, the deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households.
Second, risks to financial stability stemming from a sharp fall in asset prices remain severe. This has the potential to trigger large mark-to-market losses, which, in turn, may amplify market volatility and cause liquidity strains. In addition, the increase in the level and volatility of energy and commodity prices has generated large margin calls for participants in these markets. This has created liquidity strains for some participants.
Third, the deterioration in macroeconomic prospects weighs on asset quality and the profitability outlook of credit institutions. While the European banking sector as a whole is well capitalised, a pronounced deterioration in the macroeconomic outlook would imply a renewed increase in credit risk at a time when some credit institutions are still in the process of working out COVID-19 pandemic-related asset quality problems. The resilience of credit institutions is also affected by structural factors, including overcapacity, competition from new providers of financial services as well as exposure to cyber and climate risks.
Watch the Loan Market
I wrote earlier about the losses taken on the Citrix syndication, and how one canary in the GFC coal mine was when the dealer banks were stuck warehousing credits to the likes of Boots.
Now it is reported that the bond offerring for Apollo’s acquisition on Brightspeed has been pulled.
Banks Said to Shelve $3.9 Billion Debt Sale for Brightspeed LBO (Bloomberg)
Watch this space.
Levine, UK Pensions Got Margin Calls, Bloomberg