Bank of England warns of material risk to financial stability
bbc.co.uk
bbc.co.uk
England in particular, might be starting to unravel. England enjoyed a central stage in the world, due to the British Empire, and is used to being in that position. It's not quite clear what competitive advantage England brings to the table today, except remnants of that empire:
- Interest from colonial theft. A lot of places want their stuff back. That makes things a little bit brittle.
- Debt.
- Central role of the English language and ties to Commonwealth states.
I don't think any of that is permanent advantage.
UK controls some of the biggest tax havens in the world.
Most of the ones I know are former colonies.
If you wanted a Double Irish With a Dutch Sandwich, that never hit any current UK country. Ditto for Caribbean nations.
UK is deep into sleazy financial schemes, but I didn't think it was a major player specifically here.
https://thoughtmaybe.com/the-spiders-web/
This was by design as a way to keep UKs importance post empire.
> The charity’s list of the “world’s worst” 15 tax havens includes the Cayman Islands, Jersey and the British Virgin Islands, which, like Bermuda, are under the sovereignty of the UK. It warned that allowing these territories to act as tax havens “undermines Britain’s efforts to be an outward-facing, responsible member of the international community”.
https://www.theguardian.com/world/2016/dec/12/bermuda-is-wor...
The new government came in and destroyed that confidence with proposals for wild tax cuts for the wealthiest without showing any credible plan that leaves Britain able to pay debts and not tank their economy.
The gist being that pension funds hedged with derivatives that are dependent on small movements of bond rates. However, since the rates increased quickly, the pensions needed to sell more bonds to fund their margin calls, which further caused a need to sell more bonds. They started their own death spiral.
Basically:
1. A pension fund has to pay a $100 pension in 30 years (=liability) [1]. So, it buys a 30 year bond today (=asset) that pays $100 in 30 years. The asset and the liability are matched, and it is flat rates: long one bond (which it bought), and "short one bond", namely the pension it has to pay. +1 -1 = 0
2. However, rates have been quite low over the last two decades, making bonds expensive. So, the pension fond decides to try something new: mix bonds with stocks. They have higher expected returns, so it can get away with buying a bit less upfront, say half a bond and some shares. There will be a shortfall, but if the shares outperform the bond, as expected, it will sort itself out in 30 years.
3. Now the pension fund is long half a bond (which it bought), and "short one bond", namely the pension it has to pay, so in total not flat, but short half a bond: +0.5 -1 = -0.5. This means that the fund is unhappy when bonds rise in price, ie yields fall.
4. But even though rates were low two decades ago, they have fallen even lower after the GFC etc. [2] So, funds were unhappy, as they appeared to get worse shortfalls. So, they got the great idea of hedging, ie synthetically going long bonds: happy when bond prices go up, yields fall.
5. But recently, yields have shot up, bond prices fell. That's good, per se, for the pension funds - they're naturally short bonds, after all. Except that now they've hedged - and their hedges went massively against them.
6. Bonds are so cheap now, with high rates, the pension funds should be buying them. But instead they might be forced to sell to cover their margin calls, driving bond prices down even further, and ... we're in the spiral you mentioned.
[0] https://www.bloomberg.com/opinion/articles/2022-09-29/uk-pen...
[1] They actually have to pay a pension more or less every year over the next N years, but one can simplify this particular story by just picking one year.
[2] see e.g. https://fred.stlouisfed.org/series/DGS10 (click on "MAX" to see the full history)
Ie the books need to balance today, even though they're always going to balance in 30 years.
You seem to be suggesting that they took an unnecessary risk.
Is this my misunderstanding or yours or is it a combination?
The problem is that as rates fall, the shortfall increases. That's still just an accounting artefact, but it looks bad. To mitigate the bad look, the funds entered real hedges, which are now (with rates moving the opposite way) blowing up.
So, my understanding is that the funds took a real and unnecessary risk to mitigate what was basically just "bad optics".
The hedge is because they moved to stocks because of low yields on bonds.