The common wisdom is that the financial markets punished Liz Truss and her Chancellor of the Exchequer, Kwasi Kwarteng, for their plan to cut taxes and increase deficit financing. However, Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, in a Bloomberg Opinion article (also appearing here in the Washington Post), and others argue that the Bank of England is responsible for the end of the Liz Truss government. Kocherlakota writes:
The common wisdom is that financial markets “punished”
Truss’s government for its fiscal profligacy. But the chastisement was far from
universal. Over the three days starting Sept. 23, when the Truss government
announced its mini-budget, the pound fell by 2.2% relative to the euro, and the
FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to
bring a government to its knees.
The big change came in the price of 30-year UK government
bonds, also known as gilts, which experienced a shocking 23% drop. Most of this
decline had nothing to do with rational investors revising their beliefs about
the UK’s long-run prospects. Rather, it stemmed from financial regulators’
failure to limit leverage in UK pension funds. These funds had bought long-term
gilts with borrowed money and entered derivative contracts to the same effect —
positions that generated huge collateral demands when prices fell and yields
rose. To raise the necessary cash, they had to sell more gilts, creating a doom
loop in which declining prices and forced selling compounded one another.
Given this observation, Kocherlakota draws two conclusions
about the Bank of England. The first conclusion is that it failed in its
regulatory mission and did not do anything about too many pension funds
following similar investment strategies that go under the rubric “LDI” (“liability-driven
investing”). This failure forced the Bank of England to buy gilts even though
it was following a monetary policy of tightening credit conditions. Mr.
Kocherlakota makes a good point here.
The second conclusion Kocherlakota makes is more
speculative: “[The Bank of England] refused to extend its support beyond Oct.
14 — even though its purchases of long-term government bonds were fully
indemnified by the Treasury. It’s hard to see how that decision aligned with
the central bank’s financial-stability mandate, and easy to see how it
contributed to the government’s demise.” The head
of the Bank of England, Andrew Bailey, denies that he was trying to force Liz
Truss out.
The Liz Truss government is history, but going forward this
aspect of her downfall demonstrates potential problems in financial markets as
interest rates increase. The advice that pension funds and other institutional
investors receive may not have a full discussion of the risks, and regulators
may have difficulty identifying these issues before they become major problems.
In the early 1980s when I was working on financial market
issues at the U.S. Treasury, pension funds investing to manage their liabilities
for defined benefit plans were generally advised “to immunize” their balance sheet.
One way of doing this was to strive to have the same “duration” for their
assets as for their liabilities. (Duration is not maturity; rather, in its
simplest form, it is an average of the time to each cash flow, including interest
payments, weighted by the present value of each payment.) When the durations
match, a given change in interest rates will produce offsetting changes equal
in magnitude to a pension fund’s assets and liabilities. For example, an increase
interest rates will decrease the current value of assets but will also decrease
the current value of liabilities by approximately the same amount if the portfolio
is immunized.
Apparently, some investment advisers to pension funds have
now proposed that defined benefit plans use derivatives so that only part of
their assets are used to immunize their liabilities This frees up room for them
to invest in assets they believe will achieve higher returns. The problem is
that when interest rates increase, they may be subject to margin calls on the
derivatives that are in effect long positions in some underlying asset. If the
interest rate increase is significant, then the pension funds will need to sell
assets to meet the margin calls. If a number of funds need to do this at the
same time, this can cause problems, depending on their collective relative
size. (For those interested, here is some
marketing material for LDI for pension funds.)
As for the implications in the U.S., an article in Pensions & Investments, “U.K.'s
LDI-related turmoil puts spotlight on use of derivatives,” indicates that
people in the pension industry are thinking about it. I assume that the
Financial Stability Oversight Council, chaired by the U.S. Treasury, and its member
agencies are also looking at this issue, and, one assumes, that the Labor
Department, which has responsibility for pension fund under ERISA, is also
looking at it.
Of course, the move by corporations to offer their employees
defined contribution plans rather than defined benefit plans means that the
share of retirement money that need some sort of immunization strategy has
declined. The Pensions & Investments article suggests that the risks
of something similar happening in the U.S. to what happened in the UK are not that
great, but of course the regulators have access to more complete information,
should they choose to ask for it, than do reporters.
While it may be true that LDI, as implemented in the U.S.,
does not pose a systemic risk in the U.S., though it may be a significant risk
to some particular defined benefit plans, there may be other systemic risk
issues in the U.S. and internationally as the Federal Reserve increases
interest rates. One aspect of the 2008 financial crisis highlights the problem.
I remember that even shortly before the crisis hits in full force, many investment
professionals were arguing and providing detailed charts in support of their
contention that the subprime mortgage market was relatively small and that
problems there would not be a big deal. Many probably even believed that.
I hope the U.S. regulators learned from that experience and
can put aside their turf issues and their “clientitis” inclinations and examine
what dangers may be lurking. The Federal Reserve, to its credit, has made no
secret of what it intends to do in the coming months.
