The past two weeks have seen a spike in the use of the phrase ‘Lehman moment’, thanks to the policies of the new government in the UK. Many of us got to learn about Wall Street’s creation of exotic derivatives such as CDOs and CLOs which turned toxic during the Lehman crisis. The equivalent this time from Wall Street is LDI or Liability-Driven Investment. Ben Hunt, the author of the brilliant blog Epsilon Theory helps us understand in laymen terms what exactly is LDI and why it could potentially pose a risk to the global financial system. For those who are not from the finance industry, Ben does us a favour by starting with a primer on how money and interest rates work to set the scene before helping us with a tutorial on LDI, all in plain simple English. If you would like to get a grip on what’s brewing in the global financial system, this blog is perhaps the easiest way. For a primer on monetary policy, you might want to read the first half of the blog. If you are familiar with the money system, you can dive straight in from here:
“Quite literally, LDI is a hedge fund strategy. It is a strategy to hedge your liabilities by investing in a way that should make money and offset whatever is making your liabilities go up, which is interest rates going down. Specifically in the case of UK pension funds, it is an investment program that uses leverage – borrowed money – to bet on interest rates continuing to go down. The idea is that every dollar you make from this bet will offset a dollar increase in your liabilities, and that every dollar you lose from this bet will be offset by a dollar decrease in your liabilities. It is a pure bet (called an “interest rate swap”), where every day there is a winner and a loser. It doesn’t cost you much cash money to set up, maybe 10% of the total amount that you’re betting on (your 10% earnest money is called “initial margin” and the total amount that you’re betting on is called the ”notional” of the swap), and you can use the other 90% of the amount you’re betting on – money that you would otherwise have used to buy 100% of the asset – to make other investments. That other 90% is leverage.
Now here’s the kicker. The pension consultant team can prove to you that this is reward without risk. They can prove this because they can show you the past thirty years of betting performance with this interest rate swap, how you always end up ahead by investing in something else with that leverage, how the risk of something going wrong is vanishingly small because the volatility of that interest rate swap has been really low over that entire span of time. Sure, there was a little spike in 2013 with the so-called “taper tantrum”, but nothing you couldn’t handle. They will speak to you about “VAR” and “99% confidence levels”, and you will believe them because the math is correct and who are you to argue with math?
And then the math broke.
And then interest rates went sky-high as the Fed hiked a lot and the Bank of England didn’t, racing higher in a way that hadn’t been seen in the past 30 years.
And then the next morning, the bank on the other side of the bet emailed you to say that you owe them a lot of money because UK interest rates are going sky-high. And you only have until that afternoon to pay in full. In cash. This is a “margin call”. But you don’t have a lot of cash sitting around, so you have to sell some other assets – almost certainly government bonds – to get enough cash together to pay off your bet with the bank. You get a terrible price on the bonds you sell, because their value has gone down as interest rates have gone up. The terrible price gets more and more terrible as the day goes on, as everyone smells the blood in the water. But you survive. You take a gruesome loss on the bonds you had to sell, but you survive.
And then interest rates went sky-higher as Truss and Kwarteng unveiled their goofy plan, racing up in a way that hadn’t been seen … ever.
And then the next morning, the bank on the other side of the bet emails you to say that you owe them a LOT more money because UK interest rates are going even sky-higher. And you only have until that afternoon to pay in full. In cash. But now you have zero cash, so you have to sell a LOT of government bonds to cover that margin call. But yesterday’s terrible price of those bonds is … wait … this can’t be right. This price is impossible. There are no buyers for these bonds. None. No bid. You’re not going to be able to make the margin call to the bank on the other side of the bet. Which means that you are … ruined. All of the pension assets are now forfeit, because that’s what happens when you can’t make a margin call. The bank will sell your assets at whatever fire sale price they can get. Because that’s what banks DO.
Congratulations, you turned a long-term investor into a freakin’ hedge fund, and a miserably managed one at that. You killed your pension fund. But hey, your liabilities that will be due in …[[checks notes]] … twenty freakin’ years went down! LOL.
So the chairman of your board makes a call to a buddy at the Bank of England. They’ve known each other since they were in school together. And this isn’t the first call that his buddy has gotten that morning. This is happening to every pension fund in the country. This is a Lehman moment.
So the Bank of England does exactly what they have to do, what they were created to do (other than shape the price of leverage). They become the buyer of last resort. They pledge infinite money – tens of billions of pounds if required – to buy those UK government bonds that no one else wants to buy and the pension funds have to sell. They bail the pension funds out. And the banks to whom they owed the bet! Because that’s what central banks DO.
BTW, this last point doesn’t get nearly enough attention. When a government bails out a gambling debt that a big asset owner suffers against a big bank – like when AIG lost tens of billions of dollars in a big bet in 2008 with Goldman Sachs, and the US government paid off that debt – they’re not just bailing out the asset manager, they’re also bailing out the bank.
Anyhoo, since that happened last week, the pound has stabilized. Gilts have stabilized. Everything has stabilized. Whew! Lehman moment averted. Lesson learned. Glad that’s over!
Except that it’s not.
It will take years to unwind these LDI programs, if they ever are, in fact, unwound. The consultants are hard at work, I’m sure, reassuring everyone that this can’t possibly happen again. More fundamentally, every UK pension fund has taken a series of body blows here. Every UK pension fund has a couple of broken ribs and I’d be surprised if there’s not internal organ damage for some. It always takes a couple of months for the final casualties of these moments to reveal themselves, much less if there’s another shock.”
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