A £1.5TRILLION DEATH SPIRAL

Is the real scandal that reckless f inanciers were able to risk so much of our pensions in what very nearly became...

greater rewards tend to carry greater risk. And with pension funds becoming more and more comfortable using LDIs to dramatically ‘leverage’ their holdings – at times using them to purchase £3 of gilts for every £1 they actually invested – they would inevitably become sensitive to changes in market conditions.

Specifically, as Van Zwol predicted back in 2019, LDIs were vulnerable to rising interest rates because such changes inevitably lead to a commensurate rise in bond yields. That in turn reduces the value of gilts held by pension funds, which then leave those funds needing to raise extra capital to cover existing obligations.

In the early months of the year, that is exactly what came to pass. In a bid to combat inflation – which became especially critical following Russia’s invasion of Ukraine – central banks began slowly and surely ratcheting up interest rates from their historically low levels.

While the pace of change was initially gradual, meaning pension funds could cover their positions, the change began to spook some industry experts, including Calum Mackenzie, a partner at AON investments. In June he published a research note warning that the ‘seemingly sedate’ world of bonds and LDIs was being ‘rocked by the sort of rises in yields that we’ve not seen for decades.’

Mackenzie urged pension funds to ‘dramatically reduce their risks’. A colleague from the consultancy Mercer at the same time reckoned that leverage ratios were ‘moving towards critical levels’. Not long afterwards, Mackenzie pointed out that some LDIs had already fallen even further than the benighted crypto-currency Bitcoin and were poised to drop still more.

Yet neither the industry nor regulators seemed to act. Indeed, as recently as July, an article by a writer in the Financial Times noted that: ‘LDI managers claim that their activities pose no systemic risk and I read the Bank of England financial policy committee’s silence as agreement.’

Events of recent days would, of course, prove them (and the Government) quite wrong. Negligent, even. Trouble began on Monday of last week when Chancellor Kwasi Kwarteng unveiled a colossally expensive energy price cap, limiting the total amount that households and businesses will pay on their bills.

That caused investors to lose confidence in the Government’s ability to service its debts, meaning that the interest rates it was forced to pay on gilts ticked upwards. On the Thursday the market was again spooked when the Bank of England’s monetary policy committee chose to increase the base rate by 0.5 per cent – significantly lower than the 0.75 per cent that the Federal Reserve in America had recently plumped for. This had the effect of making UK gilts less attractive.

Finally on the Friday the Chancellor’s ‘mini-Budget’, containing tens of billions in further uncosted tax cuts, led to more of the same. By early this week, gilts which had been worth £3.50 in January were valued at as little as 50p.

For pension funds which held LDIs, this caused immediate problems. The UK gilts they were using as collateral on other investments were suddenly worth an awful lot less and cash was needed to plug the gap. Unfortunately, the only way they could raise cash was to sell large quantities of gilts, which in turn had the effect of driving the price even lower.

Of course, that meant they needed even more loot. And so a sort of vicious circle was created.

‘I have called it the death spiral,’ Mackenzie said last night. ‘That’s what we were in. A sort of volatility vortex. It became self-fulfilling. Pension funds were essentially eating themselves.’

For a few short hours, early on Wednesday, the market became effectively paralysed. That forced the Bank of England to take dramatic action, stepping in as a sort of ‘buyer of last resort’ and agreeing to plough about £65billion into gilts over the coming weeks.

As the dust settles, and taxpayers count the cost, there will naturally be calls for a prompt investigation into how pension funds were allowed to invest billions in such high-risk products. Smooth financiers, who for years profited from these exotic deals, will shrug their shoulders while politicians deflect and regulators seek others to blame.

History, meanwhile, suggests no one will be properly held accountable. And therein lies the real scandal. For as so often when financial markets implode, the outrageous fact is that this was well and truly a crisis foretold.

Volatility vortex led to funds essentially eating themselves