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Not sure if this is exactly Culture War, but I think if anybody can tell me what the heck is going on, you lot can 😁
Okay, so the UK has a new monarch, a new Prime Minister and in the past couple of days, a new budget. And now it looks like a new financial crisis.
Can anybody explain to me, in the manner that Chesterton describes Arnold, with "a smile of heart-broken forbearance, as of the teacher in an idiot school, that was enormously insulting" what has caused this kind of meltdown? I'm cribbing from The Guardian, which is trying to explain what is the problem, but my big difficulty is that I don't understand why the Bank of England had to do this. How did the British economy get to the state that the pound is dropping like a metaphor in Amazon's "The Rings of Power" and the currency apparently would have been worthless?
And why is anybody surprised by the tax cuts? They're a Tory government, the first thing they do when they get into power - or when a new PM is hoping to take over - is announce swingeing tax cuts for the better-off (along with swingeing cuts in public spending). So why is everyone now going "Oooh, that's a bit dodgy"? The only surprise for me is that it's Kwasi Kwarteng who is the guy in charge of the Budget instead of Rishi Sunak, but I suppose Rishi - being disappointed in his expectations to succeed Boris - has decided to spend more time with his family('s billions).
I’m going to paste in Matt Levine’s newsletter bit because it’s so incredibly good.
Here is a simple model of a pension fund. You know you will need to pay out a bunch of money 30 years from now, so you buy some 30-year government bonds and hold them to maturity. When the bonds mature in 30 years, you have money, which you give to the pensioners, and you’re done. This model is obviously oversimplified, [1] but it’s a good start.
Let me make three points about this model. First, a financial point: Doing a pension fund this way is expensive. Thirty-year UK gilts (government bonds) paid about 2.5% interest this summer. If you want to have £100 in 30 years, and bonds pay 2.5%, you’ll need to put aside about £48 now, which will grow at 2.5% over 30 years into £100. [2] If you are a company or government, you might not be jazzed about putting aside almost half the money now to pay pension obligations in 30 years. What if you bought some stocks instead? If stocks return 8% a year on average, you can put aside just £10 now to get back £100 in 30 years. That’s a much better deal, for you, now. Of course the gilts pay 2.5% guaranteed, while the 8% stock-market return is just a guess; in 30 years, you (and your pension beneficiaries) might regret your riskier choice. But it saves you money now, and it’ll probably work out fine. Or, you know, you do some mix of super-safe gilts and riskier corporate bonds and stocks, etc., still targeting £100 in 30 years but putting less money in now and taking more risk to get there.
Second, a financial-stability point: Structurally, pensions are about the safest form of investing. Most big investors in financial markets are, to some degree or other, structurally short-term, in ways that make markets fragile. Banks borrow most of their money short-term (from depositors, from capital markets), and if there’s a run on the bank then the bank will need to dump assets to pay back depositors. Mutual funds let their investors take money out every day, and if a lot of investors want out then the funds will have to dump stocks to give them their money back. Hedge funds let investors take money out and also tend to borrow money from prime brokers; if their assets go down then they will get margin calls from brokers and will have to sell assets to meet them. The common theme is:
You buy some assets with other people’s money.
The assets go down.
The people — depositors, investors, prime brokers — call you up and say “you used my money to buy assets, and the assets went down, so now I want my money back.”
They have the right to do that.
You have to sell assets to pay them back.
This makes the price of the assets go down more.
Go to Step 2.
More or less every bad story in financial markets is this story, a “deleveraging” or “run on the bank.” Pensions are immune to this. Pension funds own assets (gilts, stocks, etc.) with other people’s money, in the sense that they are ultimately supposed to use those assets to pay benefits to pensioners. But the beneficiaries can’t take their money out if the fund has a bad year. They just have to wait. There are no runs on pensions. The pension has to come up with £100 in 30 years, but that’s it; it can’t be forced to sell early along the way.
This means, for one thing, that if you run a pension you can confidently invest in risky assets like stocks: If stocks go down one year, you can make it up next year; you’re not going to have to shut down your pension fund because investors withdraw money after a year of bad returns. It also means that pensions are not supposed to destabilize financial markets: They are long-term investors and are not forced to sell when markets go down.
Third, an accounting point. Take the simple model of a pension: You buy a bond today to pay £100 in 30 years. I said above — with some simplification — that you pay about £48 for that bond. That is the value of that bond: The value of getting £100 in 30 years is £48 today. How do you account for that? What does the balance sheet look like? At some conceptual level, the balance sheet looks like “in 30 years I will have pension liabilities of £100 and assets of £100,” so it balances. But in practice accounting doesn’t work that way. In practice you will record the value of the bond as an asset, today, at £48. But by the same logic, you will record the value of your liability at £48: The cost of paying £100 in 30 years is £48 today, so you have assets of £48 and liabilities of £48 and it all balances.
What happens if interest rates change? Let’s say that the interest rate on 30-year gilts falls to 2%. This means that the market value of your bond goes up, to about £55. Do you have a windfall profit? Can you sell a portion of the bond? No, of course not. The market value of your bond has gone up, but you don’t care about that. The bond, for you, is a long-term, hold-to-maturity investment. For you, the bond pays £100 in 30 years; you don’t care about its market price now. But by the same logic, the present value of your liabilities goes up: Your obligation to pay £100 in 30 years is now “worth” £55, using a 2% discount rate. So your balance sheet still balances.
In the simple case, none of this matters and it is sort of a confusing fiction. You have to pay £100 in 30 years, you have an asset that pays £100 in 30 years, you’re done; market fluctuations don’t affect you at all. Accountants will want you to record the value of your asset and the value of your liability at their discounted present value, and that value will fluctuate with market interest rates. As rates go up, the value of your bonds will go down but the discounted cost of future pension benefits will go down; as rates go down, the bonds will go up but your cost will go up too. In the simple case these things will always offset and won’t trouble you very much.
But once you move beyond the simple case this gets worse. Let’s say you have to pay £100 of benefits in 30 years, and you plan to pay for that using half bonds (gilts worth £24 today) and half stocks (stocks worth £5 today). If gilts yield 2.5% and stocks return 8% per year for 30 years, that will give you £100 in 30 years, enough to pay those benefits. But today, you have assets of £29 (£24 of gilts and £5 of stocks), and liabilities of £48 (the present value of that £100 pension obligation in 30 years at a 2.5% discount rate). So your pension is underfunded, by £19. [3] It happens! It might be fine, if you get the returns you want. But it could make you nervous. One way to overcome this nervousness is to invest in even riskier assets with higher returns, so that next year you have, you know, £33, and are less underfunded.
The bigger problem is what happens when interest rates change. Again, say that the interest rate on 30-year gilts falls to 2%. Now you have £55 of liabilities (the present value of your pension obligations discounted at 2%). The value of your gilt holdings has gone up to £27.50 as rates fell. The value of your stock holdings might not have, though; stocks don’t move automatically with interest rates. Still, let’s say that your stocks have gone up, by 20%, to £6. Now you have £55 of liabilities and £33.50 of assets. You are underfunded by £21.50 instead of £19, which is worse. You have “lost money,” in a very accounting-fiction-y sense. Your actual pension obligations (how much you need to pay in 30 years) have stayed the same, and the market value of your assets has gone up. But your accounting statements show that you have lost money.
Notice that what this means is that, on a reasonable set of assumptions, pensions are short gilts: They lose money (in an accounting sense) whenever interest rates go down (and gilt prices rise), and they make money (in an accounting sense) whenever interest rates go up (and gilt prices go down). [4] Notice also how counterintuitive this is: In its simplest form, a pension fund just is a pile of gilts. The basic default move for a pension manager is to take a bunch of money and put it in gilts. Intuitively, she is long gilts: She has a pile of government bonds, and as rates go down the value of her holdings goes up. But as long as she doesn’t put all of it in gilts, and as long as the pension is underfunded, then she is as an accounting matter short gilts.
I said above that pension funds are unusually insensitive to short-term market moves: Nobody in the pension can ask for their money back for 30 years, so if the pension fund has a bad year it won’t face withdrawals and have to dump assets. Still, pension managers are sensitive to accounting. If your job is to manage a pension, you want to go to your bosses at the end of the year and say “this pension is now 5% less underfunded than it was last year.” And if you have to instead say “this pension is now 5% more underfunded than it was last year,” you are sad and maybe fired; if the pension gets too underfunded your regulator will step in. You want to avoid that.
And so the way you will approach your job is something like:
You will try to beat your benchmark, buying stocks and higher-yielding bonds to try to grow the value of your assets.
You will hedge the risk of rates going down. If rates go down, your liabilities will rise (faster than your assets); you are short gilts. You want to do something to minimize this risk.
.. continued below
Part 2….
The way to do that hedging is basically to get really long gilts in a leveraged way. If you have £29 of assets, you might invest them like this:
£24 in gilts,
£5 in stocks, and
borrow another £24 and put that in gilts too. [5]
That way, if rates go down, the value of your portfolio goes up to match the increasing value of your liabilities. So you are hedged. You were short gilts, as an accounting matter, and you’ve solved that by borrowing money to buy more gilts. In practice, the way you have borrowed this money is probably not by actually getting a loan and buying gilts but by doing some sort of derivative (interest-rate swap, etc.) with a bank, where the bank pays you if rates go down and you pay the bank if rates go up. And you have posted some collateral with the bank, and as interest rates move up or down you post more or less collateral.
This all makes total sense, in its way. But notice that you now have borrowed short-term money to buy volatile financial assets. The thing that was so good about pension funds — their structural long-termism, the fact that you can’t have a run on a pension fund: You’ve ruined that! Now, if interest rates go up (gilts go down), your bank will call you up and say “you used our money to buy assets, and the assets went down, so you need to give us some money back.” And then you have to sell a bunch of your assets — the gilts and stocks that you own — to pay off those margin calls. Through the magic of derivatives you have transformed your safe boring long-term pension fund into a risky leveraged vehicle that could get blown up by market moves.
I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.
Anyway, as I said above, 30-year UK gilt rates were about 2.5% this summer. They got to nearly 5% this week, and were at about 3.9% at 9 a.m. New York time today. You can fill in the rest. Here are Loukia Gyftopoulou and Greg Ritchie at Bloomberg News:
And here is the Financial Times on the BOE’s intervention:
And FT Alphaville has two very good explainers of the LDI problem, one by Toby Nangle and another by Alex Scaggs and Louis Ashworth, which I have drawn on here. And here is Nangle’s prescient LDI explainer from July. Modern finance made UK pensions vulnerable to runs, and then there was a run on those pensions, and the Bank of England had to step in to buy gilts to save them, because that’s what happens in a bank run.
Problem with this analysis and I’m familiar with the pension fund accounting and this formula is it’s not a perfect representation of whether you will be able to pay your future liabilities. It’s a good way to estimate your funding levels.
Embedded in all this math is an equity risks premium. When equity risks premiums increase your future returns are higher. Long story short actually hedging out a made up formula for estimating funding made them take a hedging risks that isn’t perfect for telling you if you will actually fund your liabilities.
Hence it’s a dumb formula and they hedged something they probably didn’t need to hedge. Also it was hedging nominal rates when one benefit of current markets is a great deal of the change in nominal rates is a change in real rates which means when they roll their current bonds (assume they own a lot of corporate bonds of less duration) they will be getting higher returns on the asset side of the equation.
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Thanks for that, this explains to me why the pension funds were threatened (and yeah, I have noticed that a lot of governments have been really tempted to dip into pension funds because 'well the money is just sitting there and if we invest it or use it for infrastructural funding then we'll magically both spend it and increase it').
Borrow money or cut taxes, not both, seems to be the message. I don't know why Truss and her new Chancellor couldn't foresee that would be a problem, so does this mean "oh dear" for the handling of the British economy for the near future?
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Let me get this straight: Managers want to make equity returns with bond risks. Banks come up with a miracle product that promises just that. They both profit for a few years. Then of course it all goes tits up, and the state 'has no choice' but to bail them out again. They're not illiquid, they're stupid or reckless.
You could say the banks delivered exactly what they promised. Only there was a secret ingredient, the fool who magically takes the risk away from them for free.
That's not quite right. They're saying that bond yields temporarily rose due to illiquidity in the market and were expected to fall shortly, which they did. The Bank of England didn't transfer wealth to the pension fund. They acted as the lender of last resort to tide them over.
Now, if the increase in interest rates had been more permanent, the strategy could have actually failed to the point of insolvency without an actual wealth transfer. Buy that didn't happen.
If my friend acts as a lender of last resort every time I am in danger of getting margin called, that is a valuable service, worth money, even though no money needs to be transferred from his account to mine.
Illiquidity is a red herring, a euphemism for the fact that the yield of those gilts is lower than it should be, propped up by overleverage. Bond yields are rising everywhere. Which is a problem, since they've successfully "hedged" themselves against falling interest rates by making themselves vulnerable to rising interest rates through leverage. Now they're getting margin called, and the state has bought bonds above market rate to keep the charade going, rather than liquidate their positions to let the market find the true, higher, yield.
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Sure, but in exchange for this additional risk, they make it dramatically cheaper to fund pensions. I think to make a principled policy argument against this sort of arrangement, one would have to claim that the NPV of stochastic future government bailouts is less than the NPV of making the pensions much cheaper to fund.
I think I want pension funds to be stodgy, conservative, no-fun, reliable old plodding donkeys, not flashy exciting high-risk high-yield racehorses. 'Way cheaper now' has to be paid for eventually, and it can go sideways just like this did.
That doesn’t exists in the real world of being “stodgy conservative”. Transferring money from today to the future is always going to have a lot of risks.
There’s no risks free way of transferring consumption today into consumption tomorrow. It involves some part of society investing surplus today into capital investments that are fruitful tomorrow.
You could say just buy government bonds. But if everyone does that then government bond yields go down (potentially even negative) and someone needs to a credible borrower today that will pay you your capital tomorrow when your pensioners want to consume.
The US government of course does this with social security but that even runs into issues of population pyramids and whether social security will give much real spending power when their are more retirees than young caregivers/workers.
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How much should society be willing to pay for that preference? I don't think your opinion is able to graduate from irritable mental gesture to serious policy preference unless you have some inkling of the relative costs involved.
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You mean it’s a legit government subvention of pension funds in the form of an unofficial put, and everyone knows but don’t say. So you agree the claims of illiquidity and 'no choice' are bunk, missing the forest for the trees.
I have a few objections:
Moral hazard: encourages risk-seeking behaviour, causing greater problems than anticipated, currency crisis etc. The best thing for them would be to flip for the money repeatedly, get the most out of that put.
Leakage: the most reckless banks and managers take a larger cut of the profits in good years, sucking up the subvention.
Lack of transparency/uncertainty: Taxpayers are unaware the subvention was in place until the crash. Since it’s an unofficial guarantee, Market participants can never be sure of the bailout, leading to uncertainty and malinvestment .
Unfairness: The simple and honest worker-investor who decided to accept the risk of equities for his pension, did everything right, saw through the lies of bankers, doesn't cause systemic risk, has a cheap pension fund. As a reward, he is outcompeted by this chimera of governement subventions and banks.
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