TheDebacle of Great Britain LDI investments

[Running_Man]

It is extraordinarily concerning having read what Black Rock has sold to all the pension funds in Great Britain. 2/3 of the pensions have invested in what is called the LDI pension scheme.

The short version is the pension has government bonds it sells and in a repo agreement agrees to buy back a future date for a fixed rate, earning as much as bonds were paying in the low interest rate enviroment of 2016-2021.

With the cash in hand for the sale of the bonds, pensions would sell on average 4X times resulting in a 4X cash flow for the pension fund to the point of where these derivatives were 1.8 trillion in value inUSD in Great Britain's pension out of a total pension fund in Great Britain of 6.1 Trillion in USD or 30% of the average pension funds portfolio. This made up the fixed asset portion of the funds, freeing them up to invest heavily in hedge funds and growth stocks.

This situation is dire and is going to result in tragedy in the UK unless interest rates are reversed to the downside which is going to inflate the home prices. At present 33% of all the debt issued by the UK is held in derivative form by the pension plans under these LDI plans.

This current lull is a temporary reprieve and going to be a major blow for Great Britain. Most pension funds are going to be forced to liquidate stocks and bonds to cover the LDI exposure.

Government is hoping for a stop in the increase to allow current deductions from future pensioniors paychecks to backstop the LDI but that merely means a transfer from the pension fund to the likes of Black Rock who have issued most of these products.

What has been done to the pension funds of Great Britain is terrifying experiment in investing

https://www.reuters.com/markets/eur...ven-investment-strategy-explained-2022-10-04/

 

[audreyh1]

Links for more info, background? Thanks!

 

[jldavid47]

Which only reinforces Warren Buffet's statement that derivatives are financial weapons of mass destruction. Especially when the derivative holdings have negative gamma (as in this case). Those pension fund managers probably bought into faulty models that made bad risk assumptions. What has happened isn't a Black Swan. It was entirely predictable. Interest rates weren't going to stay near zero forever. Anyone who believed that and managed money based on that assumption is a fool.

 

[Lsbcal]

I never understand these financial engineering schemes and especially their knock on effects. Will I experience collateral damage? So I think the best I can do is to try to hold assets that I have confidence in and can ride out in a severe storm.

Example: In 2008 we saw TIPS going screaming up in yield (declining prices) because gamblers had to sell something to raise cash as their ugly assets were cratering. If you held TIPS or TIPS funds even those safe assets were loosing money in addition to your stocks. So I only buy individual TIPS bonds that I know I get decent returns on and can be held to maturity. In this case I can ignore short term volatility. For now the nominal bonds are in short term Treasuries.

Since the Fed has not shown signs of backing off from extreme hawkishness, we may see something break in markets. I do not know how to assess the risks until the collateral damage gets going. Right now Fear is in the ascendancy.

 

[Running_Man]

What they are doing is simple in constuction, they have Government Bonds which they sell to another party agreeing to buy back at the same price in future and in exchange are given a cash stream. Just like shorting stocks. they take the money and buy more, which is increasing demand and lowering interest rates which makes the initial purchases favorable and continue doing this until levered 4-5X. Now to unwind means 4-5X times as much selling and in the meantime they used the ultimate money to buy equities which are falling in value as well.

This is remarkably similar to the housing crisis where people were buying 3-4 condos with no money down mortgages because home prices always went up. The LDI's are about 60% of the value of GDP

During Sub Prime crisis there was about 1.1 trillion in subprime mortgages which made up 7 percent of of the USA GDP at the time. So the effect to Great Britain's economy can be enormous with a 10X factor as a percentage of the Britain economy compared to the USA subprime issue and I think the scope of the problem is beyond redemption.

https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=GB

 

[deserat]

What they are doing is simple in constuction, they have Government Bonds which they sell to another party agreeing to buy back at the same price in future and in exchange are given a cash stream. Just like shorting stocks. they take the money and buy more, which is increasing demand and lowering interest rates which makes the initial purchases favorable and continue doing this until levered 4-5X. Now to unwind means 4-5X times as much selling and in the meantime they used the ultimate money to buy equities which are falling in value as well.

This is remarkably similar to the housing crisis where people were buying 3-4 condos with no money down mortgages because home prices always went up. The LDI's are about 60% of the value of GDP

During Sub Prime crisis there was about 1.1 trillion in subprime mortgages which made up 7 percent of of the USA GDP at the time. So the effect to Great Britain's economy can be enormous with a 10X factor as a percentage of the Britain economy compared to the USA subprime issue and I think the scope of the problem is beyond redemption.

https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=GB

I seem to remember what bothered me most about the 2008 crisis here in the USA is the ratings agencies had rated the derivatives based on these subprime mortgages as AAA, so people bought them thinking their risk was minimal, when in fact the risk was much higher due to the high probability of default on the underlying mortgages.

From a behavioral standpoint perspective, I saw people in CA get hoodwinked. I had gone back to CA for a small time to get my house ready to rent and my next door neighbor who worked in construction and his wife who was a receptionist told me that were selling their house and buying a new one in the development nearby for twice as much as their current house was worth. At the time, I also redid my mortgage to a lower rate and a shorter term (10 years). When the mortgage rep came to my house (yes!) to sign the papers, she asked me if I as going to take any of the equity out. I said no, I wanted to pay off the house. I asked her then how many ten year mortgages she had written - one - mine; how many 15 year - about 3; how many 30 year - all the rest. I then asked how many took the equity out. She said most and they bought boats and vacations. I was flabbergasted. This was in 2001-2 when the houses in CA were becoming much more expensive and all of the teaser 0 percent loans were being offered. I knew that could not be sustained.

We saw the crash coming in 2008 and luckily sold our house near the top. A year later the house was worth what I had purchased it for (~$100K difference). I also met a lady on the train who was going to have to declare bankruptcy and lose her house. As I heard her story I thought to myself she should not have bought that house as she could not really afford it (0 teaser, variable loan).

I look at the LDI similarly. They leveraged themselves to try and ensure they could provide the long-term payouts but didn't properly manage the risk. They also sold this as a stable approach when in fact it wasn't. Unfortunately for many people in the UK, they use defined benefit pensions as a larger part of their income streams for retirement. It seems this is yet another type of regulatory capture that allowed risky behavior (ie the supposed government watchdogs didn't do their job) on the part of the pension providers. As usual the citizen gets caught holding the bag.

 

[Running_Man]

They guaranteed the Triple Lock on pensions today in Britain, which is the greater of inflation, average weekly earnings or 2.5% per year. So this means next years pensions are going up 10.9% next year with mostly about 10-25% decrease in assets depending on the pension fund.

 

[jldavid47]

I look at the LDI similarly. They leveraged themselves to try and ensure they could provide the long-term payouts but didn't properly manage the risk.

"Didn't properly manage the risk" is one possibility. Here are two others:

1) They didn't understand the risks enough to manage them effectively
2) They didn't think there was any practical risk at all

Both are scary possibilities, especially #2. I would posit that most pension fund managers work within a paradigm and if that paradigm breaks, they are clueless. (I admit in advance I could be completely wrong about that).

 

[jldavid47]

They guaranteed the Triple Lock on pensions today in Britain, which is the greater of inflation, average weekly earnings or 2.5% per year. So this means next years pensions are going up 10.9% next year with mostly about 10-25% decrease in assets depending on the pension fund.

And where are they going to conjure up the funds to do that? I think they are in a real bind.

 

[aja8888]

So how long will Truss hold her job? She has displayed her stupidity and now is eating crow. Who's next in line?

 

[all4j]

"Didn't properly manage the risk" is one possibility. Here are two others:

1) They didn't understand the risks enough to manage them effectively
2) They didn't think there was any practical risk at all

Both are scary possibilities, especially #2. I would posit that most pension fund managers work within a paradigm and if that paradigm breaks, they are clueless. (I admit in advance I could be completely wrong about that).

Well, I have a somewhat different understanding of what happened than earlier poster. I commented in another thread about it before, so won't repeat here. I mention that to give context to these thoughts....

As I understood it, the swaps that were in place did have -- for lack of a better word, but not sure this is right word -- buffers for interest rate fluctuations. They took the highest historical daily variance & hedged a bit more than that. Ordinarily, as rates start to rise (price falls), money will be attracted to the 'bargain' price. These new buyers may very well be outside the home market (in this case, the UK), which would involve swapping their currency for the british pound to buy the gilt.

Fire started due to what was announced & when. Things weren't strong going in. Ukraine war impact on energy hitting inflation, jobs being lost, etc Turned quickly into a falling knife scenario. Selling triggered margin calls, which meant selling, which drove price down, which triggered more etc. Some potential customers saw pound dropping & sat out chance to buy at lower price. I don't recall the numbers but the interest rate fluctuated well more than it had ever done...then again the next day. I'm sure some would call it a 'black swan' situation.

Posters on this board aren't professional, but almost hard to ignore the recency bias that persists. In the UK pension matter, I'm not clued in to know how well understood the risk was. Most of these hedges are pushed by 3 companies, so an approach can fairly easily become an industry standard. For all I know, there were some saying it was dangerous from a financial view & others saying politically we must proceed. I just don't know.

I do agree the going forward solution isn't obvious (to me anyway). In UK, few mortgages are 30 year fixed & a large number will be having interest rate on their mortgage reset over coming months. Speculation I've seen is that many simply can't afford that with everything else going on.

 

[JoeWras]

So how long will Truss hold her job? She has displayed her stupidity and now is eating crow. Who's next in line?

About 18 hours.

Maybe Johnson?

"Here comes the new boss, same as the old boss." -- Pete Townshend, apparent prophet

 

[Born2Fish]

About 18 hours.

Maybe Johnson?

"Here comes the new boss, same as the old boss." -- Pete Townshend, apparent prophet

They better get on their knees and pray, ..."we don't get fooled again".

 

[RobbieB]

About 18 hours.

Maybe Johnson?

"Here comes the new boss, same as the old boss." -- Pete Townshend, apparent prophet

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