Time to think quickly? (UK, MBS, junk bonds, gilts, panic selling, credit freeze, banks...)

Investment Analysis Clubs Macro Economic Trends and Risks
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I don’t know how many of you read Financial Times Alphaville, but it’s excellent, a very fun source of market gossip. It’s what the WSJ would be if it was a) cool b) accurate c) a stereotypical 1960’s British housewife.

You can get free limited access if you register (or via universities, libraries, etc, I believe). And a subcription to the FT is absolutely worth it.

OK. So here is a very, very interesting article:

LDI: the better mousetrap that almost broke the UK

The FT have a lot of brilliant articles about market events right now but this is the most important IMHO. It was my understanding, after reading the article, that:

  • Pension funds in the UK have been juicing up short-term yields via Complicated Investment Bank Things (LDIs) which invariably involve using hedges and swaps to generate leverage across junk bonds, Mortgage Backed Securities (MBS), and so on.

  • In theory this was done to match their gilt income stream with their annuity payout needs, but lo and behold, in past years, these funds have somehow generated a surplus. I wonder if anyone got a bonus for that, or took any risks?

  • These LDIs are

    • a) full of stuff that is priced relative to e.g. gilts (UK T-bonds) & T-bonds
    • b) backed by gilts as collateral.

  • So they are looking rather gilty right now, one might say.

  • Unfortunately, gilt prices are crashing through the floor on a day by day basis. Partly because of short rates zooming up & inflation, partly because of QT, partly because of the pound, partly because the UK has awful politicians with awful ideas.

  • And partly because everything - gilts, junk bonds, MBS - is getting sold off.

  • And those fancy leveraged hedges/swaps are getting a bit pricey to maintain.

  • Which in turn is leading to further rounds of forced selling, which worsens things even more, across the board.

  • And what is being force-sold the most? UK Gilts, since they retained the most value and nobody likes to sell off 5 units of dogplops when they can sell 1 unit of gold instead, and make the margin call.

  • Hence, via forced selling, preferentially of UK gilts, we see gilt yields/prices moving a truly colossal amount earlier in the week. Possibly US T-bonds too, I think?

  • The BOE said it would not step in to fix the market till November, but then the very next day, announced it would buy £65 billion of gilts, above market price, with the losses being passed onto the government Treasury - and in turn the taxpayer.

  • I presume this is being done to try and slow the inevitable Giltpocalypse, and in desperate hope of evading it completely. By Giltpocalypse I mean a huge crash in gilts, MBS and junk bonds all at once from an absolutely epic industry-wide series of synchronised margin calls.

  • I wonder if there is going to be ongoing steady forced selling in these markets, and possibly a huge all-at-once panic sale, and also perhaps later maybe some lawsuits against whichever investment banks sold these genius instruments to the pension funds, and possibly also investment banks discovering they have MBS and junk bonds on their books they now can’t pass on to the market… (ala 2008)

  • With that in mind - if it were me, myself- and this is not advice to you, gentle reader - I, personally would be taking a close look at all the following if I thought I had them in my portfolio or assets:

    • UK pension funds
    • The life assurers and fund management firms who run those pension funds
    • Investment banks likely to be counterparties in this trade in the UK, EU or US
    • MBS and junk bonds
    • UK gilts & £pounds balances, possibly euro government bonds.
    • Anything else likely to be affected by any knock on effects of a credit freeze and rapid movement in long term rates ala 2008.
      • i.e. Mortgage brokers, banks, property funds, UK housebuilders, …

I have a feeling there’s going to be a very fast replay of the credit freeze of 2008 as everyone realises it’s pass-the-parcel, fib-about-your-exposure time, since everyone remembers what happened in 2008 and nobody is going to trust anyone very much right now.

I wonder how long that £65 billion will last.

Hope you all find this interesting and useful. Stay safe, folks.

Best,

Lux

p.s. This is also a rehash from my own silly brain, so if there are any errors or omissions, my apologies. Characters and events appearing in this post are of course fictional and certainly are not based on real life.

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Thanks for the summary and thoughts, luxmain. It will be interesting to see how much of a problem this becomes in the next months.

I’m glad I don’t have any big investments in the UK directly.

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If anyone is interested in LDIs and the UK situation, and contagion risk, here are some high quality links I gathered for this board.

The big collateral call facing UK pension funds - July 21

Note the date. Some choice quotes:

“about the size of the government’s total debt, after stripping out bonds held by the Bank of England. This is the quantum of liabilities held by UK pension funds that have been hedged with so-called Liability Driven Investment trades”

“But accompanying this rise in yields are large losses and collateral calls for schemes engaging in leveraged LDI derivative trades. How large? An upper-end estimate, if LDI was implemented entirely through derivatives, would be a collateral call of over £380bn.”

and my favourite:

“Does this matter? LDI managers claim that their activities pose no systemic risk, and I read the Bank of England financial policy committee’s silence as agreement.”

:grin:

The reason the BoE is buying long gilts: an LDI blow-up - Sep 29th

“pension plans appear to have been caught in doom-loop of margin calls on interest rate derivatives that forced them into dumping longer-maturity UK gilts. Since then, long gilts have underperformed. It’s been carnage, frankly.”

LDI: where’s the exposure? If you answered UK life insurers, award yourself half a point - Sep 29th

“The common denominator of all those activities is that they are long UK duration, long inflation risk and long leverage. The latter means implicitly that they are short volatility.”

Lux: Good lord! AGAIN? Does anyone remember when a spike in the VIX ruined the ‘inverse vix is free money’ folks and zeroed out the inverse vix ETFs in an hour? “pennies in front of a steamroller”.

Lux: As a closing comment - the FT’s coverage and investigation of this LDI & related contagion seems world-leading at present, these articles are well worth a read. And while Britain is no longer the center of the financial universe, neither was Lehman Brothers, or LTCM, or AIG, but their contagion risk was very important for how the crash developed. Here, it’s not just one company, or even one instrument, it’s a strategy employed broadly across at least one major sector of one major economy… and who knows where else?

Oh, and check out the comments on the FT articles! There are some real gems there, such as the one highlighting the similarity between LDIs and “Portfolio Insurance” that triggered the 1987 crash by causing feedback loops of selling as things got worse… there is a comment by someone called “Ronin” that points out some key reasons why LDI were going to struggle

Hmm. I should probably stop speaking in italics now.

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It is more than Greece. AIG in fact was the center of the financial universe and what Britain is facing is pretty much on par. Just one cog, AIG, but a big cog.

Who owns the UK debt outside the Kingdom and her insurers?

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Who owns the UK debt outside the Kingdom and her insurers?

Having read the articles, and my comments, you will no doubt already know that gilts are only a part of the problem here with regard to financial contagion and knock-on effects.

To answer your question, you may find this interesting:

“US asset managers are big creditors.”

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Dunces everyone of them. No idea why people would trust them considering.

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First of all, thanks for the thought provoking writeup. I think the following is the most timely sentence to contemplate:

Lehman was more important to the American financial matrix than most realized because their computers (turned off when the ship went down) housed who were the counterparties to a large proportion of the credit default swaps in the US. Rather than a work-out, spreading the damage amongst banks it was decided that AIG would be the sacrificial lamb and pay off everyone. And everyone was connected to the US.

While the damage to the financial infrastructure of the UK is potentially devastating to them, the $64(B?, T?) question is how the distributed global markets are invested in England - post Brexit. Sure, British selling of global foreign equities could temporarily provide a headwind, but more important is how much British debt and GBP-linked derivatives are held by foreign financial firms (as well as how hedged the currency function is - as well as who the counterparties to the hedges are.

If US banks and/or hedge funds are deeply intertwined, either directly or as derivative counterparties, then this could involve the same level of disruption as the last time this show played on Broadway, but if, for example, most of the exposure is to Singapore, Australia and Zurich the global challenges will be asymmetrical.

In either case, we are watching a slow (quick?) moving train wreck of a country whose Brexit was the beginning of the end of their being a major financial force going forward.

Jeff

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Jeff,

I think it is about the weather conditions not the individual players. Inflation, interest rates, forex, corporate profits, corporate debt…particularly corporate debt.

Swaps are just derivatives for the bond markets. The derivatives can be put aside in any of these conversations. The underlying debts can not be put aside.

There was no swap market bailout in the 2009 to 2011 period. There was a bond market bailout.

That is tricky for the public. Because it makes the bankers whole on all of their risks. It was also expensive.

Again across much of the globe we have property values at highs. This also leads to problems with bonds depending on how many of the loans are securitized.

The problem with your post, if I may, is the assumption this can go away. It can’t. It is a global undoing.

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Au contrary Leap,
Bonds are a huge problem. That said, since there is no limit to the amount of derivatives (one type of which is a credit default swap) attached to a bond, leverage can distort the order of magnitude of the problem.

What I am pointing out in my last post is that the physical/geographic fabric woven by the connections between the creditors and the debtors (of both the bonds and the derivatives) which involves brokers, banks, insurance companies, hedge funds and so on, will determine which portions of the financial institutions of which countries suffer from the stress.

Jeff

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Jeff,

I am saying the bonds are the problem.

Interesting thought. If China does not bail out her bond market in the triggering events against the swaps as a player perhaps only China fails.

If we bailout our bond market, probable need, we will see a very angry mob. How do we bail out the bond market but not make the banks whole? By having FDIC take overs of the major banks as needed. By pushing their shareholders out entirely.

If the shareholders and executives are made whole that would shock not just me but the country. Fool me once…