LONDON: MODELS FIGHT IN PUBLIC!
Part 2 of 2
“British pensioners”
The crisis in an obscure derivatives strategy called “Liability Driven Investing” (LDI), used by a large number of British pension funds, is generating a worldwide disruption of government finance. The LDI mess started on September 23 with a poorly conceived budget speech by the incoming chancellor of the Exchequer, the British finance minister. The speech triggered a rapid sell-off in UK government bonds, which has now spread to equities debt and equities markets across the globe.
Were the LDI crisis following the pattern of the previous twenty-plus years, it would have been settled by a massive Bank of England bond buying package — 65 billion, in this case — that was announced just a few days after the speech. And, in the first hours and days, the central bank fix appeared to work, with calmer markets and price rallies. Then U.K. markets began to crumble again, with a further sell-off accelerating into this week. Even the U.S. Treasury market is markedly less liquid, and distress is spreading in European markets already made uneasy by the Russian invasion of Ukraine.
Who is responsible? The pension funds’ trustees and managers weren’t using LDI as part of some vast crooked conspiracy. They were trying to make up for the loss of interest income that was a consequence of at least two decades of artificially low interest rates. They needed to pay their beneficiaries without placing an excessive burden on the corporations or state bodies that are the pension plans’ sponsors.
The low rates that caused the trustees’ proble were created by near-continuous central bank bailouts of governments’ debt accumulation. Even the 2008 “Lehman” or “subprime mortgage” crisis can be traced to excessive speculation created by U.S. government-encouraged housing debt. The U.S. “Lehman” crisis was mirrored by similar housing finance crises in Britain and Ireland. The European crisis of 2011 was created by the European Central Bank’s underwriting of member countries’ state debts.
All these crises and bailouts bought just time, not solutions. The problem of inefficient companies and overpriced housing continued to be ignored. The LDI mess in Britain may be telling us that the future is here. This time, the crisis is being caused by the low interest rates and balance sheet indigestion precipitated by previous bailouts. It may be the end of the line for bailout culture.
Now, the LDI disaster is casting doubt on a key reform intended to prevent another 2008 crisis: forcing fixed income, currency and commodities trading on to central clearing houses, or CCPs. The reformers believed that by bringing all buying and selling in a financial market to a common exchange platform, a CCP would eliminate the risk of a bad actor, such as Lehman, infecting other market participants with excess speculation and failed trades.
So, with the encouragement of laws and banking regulations, CCPs proliferated across markets. Increasingly, bonds, commodities and derivatives contracts were shifted from bank-to-bank/bank-to-customer “bilateral” trades, which were financed on bank balance sheets, to “cleared”, standardized contracts that were matched on CCPs. Banks reduced the capital they committed to dealing desks so that they could finance the ever-rising volume of trading, which grew further with every crisis and subsequent central bank bailout.
Not everyone thought CCPs were a magic solution. Yes, the dissidents agreed, there was less risk of failures cascading from one bad actor to other market participants. Instead, risks that previously occurred in one or several “points of failure” were being concentrated by CCPs into one big point of failure for the entire marketplace. Because everyone is responsible, no one is responsible.
This appears to be what is happening in the U.K. gilts market. For more than two hundred years, liquidity in gilts had been the responsibility of banks under the umbrella of the Bank of England. Customers who needed cash could borrow against “gilt”-edged security.