At the @xpsgroup seminar on LDI – 3.6% of schemes admitted to not making collateral calls and another 5.3% had had their hedge taken from them. Is this good? Apparently so by the reaction since – to me it looks like a default rate of close to 10% – not exactly investment grade!

— Henry Tapper (@henryhtapper) October 4, 2022

This failure rate is acceptable to the Pensions Regulator

UK’s Pensions Regulator says ‘system coped’ with spike in gilt yields https://t.co/8B4qu71aej via @financialtimes

— Josephine Cumbo (@JosephineCumbo) October 4, 2022

“Was it a challenging period (for) liquidity? Yes, it absolutely was,” Neil Bull, an investment consultant with The Pensions Regulator, told a webinar hosted by XPS, the pensions consultancy.

“Did a lot of people put in a lot of hours to make the necessary margin and collateral calls? Yes, they did.”

“But the system coped throughout that period of time and throughout those challenges, particularly once the BoE intervened and created that stabilisation.”

Bull said the “vast majority” of pension plans had “good collateral waterfall plans in place”. These plans worked for the preservation of the hedge but only at the expense of the organisation of the schemes assets and at the cost of forced selling of assets – often well below book price. The waterfalls saved LDI but we have yet to find what they washed away of the schemes that used them.

I am not so happy that the system worked, nor it seems are the lawyers. For now we hear in the FT from an anonymous pension lawyer

“We would not have had this problem if the credit support documentation between the pension fund and the hedge providers had allowed pension funds to give collateral in the form of gilts. “The problem we’ve had is the pension funds were called to cash, so they had to sell gilts to obtain the cash.” He said he was “rapidly redrafting” a number of contracts to expand the collateral terms.

And we hear from Jacqui Reid – a pension lawyer at Sackers

“Lots of schemes we work with are sitting on material holdings of high-grade corporate bonds. Rather than selling them, some schemes are looking at ways of using them as an alternative to posting cash as collateral, for example by repo-ing them.”

There is a window when the Bank of England will repossess corporate bonds and some gilts to help with the reorganisation of assets within defined benefit schemes. That window closes on November 10th and the Bank (John Cunliffe et al) made it abundantly clear that this support is not to be confused with QE. It is time limited in its operation and the bonds and gilts purchased will be returned to the market asap.

So hopes that LDI will continue as before rest with the counterparties (the investment banks who are on the other side of the derivative contracts), accepting riskier assets than cash to meet margin calls. Are banks going to take this risk and if so – at what cost?

I am speaking not as an expert but as an inquisitive amateur, but this looks like a case of finding a way for a broken product to limp on. But with the prospect of inflation and interest rates staying high for much longer than anticipated, why are we still wanting to maintain leverage at all?

Were it possible to unwind these contracts for difference in an orderly way, would that not be better than keeping them in place just for the sake of it?

LDI was originally meant as a short-term means for schemes to retain exposure to real assets faced with the twin pressure of the 2004 accounting standards and quantitative easing. QE is no more and we would like – pension schemes permitting – to get back to the quantitative tightening that is needed as we clamber our way out of the current debt-shambles we are in.

As for the application of these standards, all of the major consultancies are now asking that the DWP funding reforms be torn up and we go back to the drawing board on how we look at scheme funding (and by extension the valuation process).

Perpetuating the shelf-life of LDI through weakening the collateral calls looks to me a case of shutting the stable door after the horse has bolted. The risks inherent in LDI were indeed crystallised by cash calls for collateral , but making collateral easier to post does not sort the fundamental weakness of LDI – which is that it is a tactical product that has been turned into a strategic investment. Borrowing has turned from an acute necessity to business as usual (something that is in itself open to legal challenge). Surely the solution to the current problem is not to make leverage easier to maintain but to find ways to reduce and ultimately eliminate it from the BAU of pension management?