Analysis: Under water: how the Bank of England threw markets a lifeline

Mercer International

02/10/2022 06:00

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      Bank of England bought bonds after pension fund pleas
    

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      Some UK pension funds faced problematic margin calls
    

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      BoE support seen as giving window to build collateral
    

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      British government's unfunded tax plan spooked markets
    

  
    By Carolyn Cohn, Tommy Wilkes and Carolina Mandl
       LONDON/NEW YORK, Oct 2 (Reuters) - Calls to the Bank of
England saying some British pension funds were struggling to
meet margin calls began on Monday. By Wednesday they were
getting more urgent and coordinated.
    Wild gyrations in financial markets in response to a
government "mini-budget" on Sept. 23 meant that swathes of
Britain's pension system were at risk, raising widespread
concerns about the country's financial stability. 
    British Finance Minister Kwasi Kwarteng's statement had
included dramatic plans to slash taxes and pay for it with
borrowing which sent government bond yields soaring. 
    In the following days, Britain's borrowing costs surged the
most in decades, while the pound plunged to a record low.
    But while these reactions were plain for all to see, behind
the financial market screens there was a hidden impact.
    At risk of blowing up were obscure financial instruments
meant to match long-term pension liabilities with assets, which
had never been tested by bond yields moving so far or so fast. 
    Among those urgently calling the BoE were funds managing
so-called liability-driven investments (LDI), a seemingly simple
hedging strategy at the heart of the blow-up. 
    The LDI market has boomed in the past decade and assets
total nearly 1.6 trillion pounds ($1.79 trillion) – more than
two-thirds the size of the British economy.
    Pension schemes were forced to sell government bonds known
as gilts after they found it hard to meet emergency demands from
the LDI funds for collateral on 'under-water' derivatives
positions, where the value is less than on a fund's books.
    LDI funds were calling for the urgent cash to shore up
loss-making positions. The funds were themselves facing margin
calls from their relationship-banks and other key financial
players.
    "We laid our cards on the table. You don't expect them (the
BoE) to give you much back because they're not going to show you
their hand, right?" said James Brundrett of pension consultant
and fiduciary manager Mercer, which held a meeting with the BoE
on Sept. 26.
    "Thank God they listened because this morning (Sept. 28),
the gilt market wasn't operating," he added.
    Facing a market meltdown, the BoE stepped in with a 65
billion pound ($72.3 billion) package to buy long-dated gilts.
    And echoing former European Central Bank boss Mario Draghi
at the height of the euro zone debt crisis, the central bank
pledged to do whatever it took to bring financial stability.
    While this may have eased the immediate pressure on pension
funds, it is far from clear how much time the BoE has bought as
shockwaves reverberate through global markets from
recently-apppointed Prime Minister Liz Truss' plan, which as
well as spooking investors drew a rare IMF rebuke.
    Chris Philp, chief secretary to the UK Treasury, said on
Thursday he disagreed with the IMF's concerns about the
government's tax-cutting budget, saying it would lead to
long-term economic growth.
    
    By the end of a turbulent week, many pension funds were
still liquidating positions to meet collateral requests and some
were asking the companies they manage money for to bail them out
with cash, sources told Reuters on Friday.  
     "The question is what happens when the Bank of England
pulls out of this market?" said Mercer's Brundrett, adding that
there is a window of opportunity for pension funds to get enough
money together to shore up collateral positions.
    "By the end of the day (Monday) we were saying if this
continues we are in serious trouble," one fund manager at a
large British corporate pension scheme told Reuters. 
    "By Wednesday morning, we were saying this is a systemic
problem. We were on the brink. It was like 2008 but on steroids
because it happened so fast," the fund manager added.
    BlackRock, another big LDI manager, told clients on
Wednesday that it would not allow them to replenish the
collateral needed to keep a position open, a note from BlackRock
seen by Reuters shows.
    BlackRock said in an emailed statement on Friday that it was
cutting leverage in the funds and that it did not halt trading
in them.
    NOT OUT OF THE WOODS
    The potential for the stress to cascade beyond pension funds
and throughout Britain's financial industry was real. If the LDI
funds defaulted on their positions, banks which had arranged the
derivatives would be sucked in too.
    The massive stress on a major economy's financial system
made global waves, with even safe-haven U.S. Treasuries and
top-rated German bonds hit. Atlanta Fed President Raphael Bostic
on Monday warned events in Britain could lead to greater
economic stress in Europe and the United States.
    
    While the BoE intervention sent yields plummeting, pushing
the 30-year bond yield back to Sept. 23 levels and easing fears
of an immediate crisis, fund managers, pensions experts and
analysts say Britain is far from out of the woods.
    No one knows how much the schemes will need to sell, and
what will happen once the BoE stops buying bonds on Oct. 14. 
    Britain's central bank is now in the unenviable position of
having postponed its plan to sell bonds, resulting in monetary
loosening, and at the same time tightening with interest rates.
    In November, it is expected to raise rates further and it
has said it will stick to a plan to sell its bonds.
    "The concern would be that the market sees this as something
to be tested and I don't believe the Bank will want to set this
precedent. This continues to leave long gilts vulnerable," said
Orla Garvey, a fixed income manager at Federated Hermes.
    Investor confidence has been shaken, not just in Britain. 
    "The situation in England is quite serious because 30% of
mortgages are heading toward variable rates," said billionaire
investor Stanley Druckenmiller. 
    "What you don't do is go and take taxpayer money and buy
bonds at 4%," said Druckenmiller. "This is creating long-term
problems down the road." 
    Standard & Poor's cut the outlook for its AA credit rating
for British sovereign debt on Friday to "negative" from
"stable", saying Truss's tax cut plans would cause debt to keep
rising.
    Meanwhile, demand for U.S. dollars in currency derivative
markets surged to its highest level since the height of the
COVID-19 crisis in March 2020 on Friday, as the market turmoil
sent investors in search of cash.
    Ken Griffin, billionaire founder of Citadel Securities, one
of the world's biggest market-making firms, is concerned.
    "It represents the first time we've seen a major developed
market, in a very long time, lose confidence from investors,"
Griffin told an investor conference in New York on Wednesday.
($1 = 0.8994 pounds)  
    <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Gilts, Sterling and FTSE250    https://tmsnrt.rs/3Ckv86N
The dollar vs other currencies    https://tmsnrt.rs/3rkgF4s
UK government bond spread    https://tmsnrt.rs/3Sx5Yro
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 (Additional reporting by Sinead Cruise, Davide Barbuscia and
Iain Withers; Writing by Megan Davies; Editing by Elisa
Martinuzzi and Alexander Smith)
 ((megan.davies@thomsonreuters.com; +1 646 223 6190;))