Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

The current situation. UK pension funds (BPM in this case) have a problem. On paper, falling interest rates lower the discount rate on the future liabilities of the fund. Makes the fund look bad. Can’t have that, say LFI. We will buy a leveraged position of long duration bonds. As rates fall, the increase in liabilities will be offset by gains in the long bond portfolio. If rates begin the rise, the losses on bonds will be offset by paper gains in the reduced liabilities. Sounds good, or as Dire Straits crooned…Money for Nothin. This will work fine, as long as we don’t get a real fast inflationary spike in rates, which of course we won’t because we know inflation is dead. Whoops…

Rates spike, liabilities do fall on paper, but the margin call on the bond long requires real money…right now. A classic liquidity mismatch. All of a sudden, pension funds have a margin call. On this latest yield spike, the central bank has to intervene in the name of financial stability. Liquidations spread to other markets as the funds scramble for cash. Normally history doesn’t repeat exactly, but rhymes. In this instance though, it’s closer to a straight rerun. This happened in Orange County, CA in 1994 when rates rose, and it’s literally used as a finance case study on risk management and what not to do. And yet here we are, just far enough along for a new generation to make the same mistake.

Rule 1 in finance…keep it simple.

Postscript – October 11, 2022

The FT has published a fabulous piece on the episode at this link (paywall). It fills in the BPM and LFI cast of characters and has some great quotes – turns out our read was pretty accurate all told…