There have been big losers from the LDI crisis. It has been going on all year but intensified following the Bank of England’s switch from easing to tapering and intensified again after the announcement the next day of the ill-fated “mini-budget”.

Con Keating and Iain Clacher stand behind an estimate of £500bn as the financial impact of the leverage created by the use of swaps and the Repo market to inflate pension schemes exposure to the long dated and index linked gilt markets. As Kerrin Rosenberg neatly put it yesterday , trying to match £2trillion in liabilities with £500bn of gilts isn’t easy.

It would be seen for most of the past 15 years , pension schemes stated ownership of these gilts exceeded their issuance by a fair margin and with this in mind advisers on and managers of leveraged LDI contracts were called on Wednesday December  7th to parliament

Much of the discussion was spent trying to understand who were the injured parties (if any). Kerrin Rosenberg admitted that there might have been some losses “at the margin” (implying not on his book).

Abdallah Nauphal, CEO of  Insight Investment yesterday told the Work and Pensions Committee that 95% of Insight clients investing in their pooled funds – kept their hedges.

I was initially suspicious that this might be “selective information”.

But he went on to say that Insight had been holding a 2% rather than a 1% collateral  buffer through the crisis, putting it a commercial disadvantage – this complaint had an authentic ring, perhaps Insight can lay claim to have been the small scheme’s friend.

Anecdotal evidence suggests that up to 50% of small schemes lost all or part of their hedges, so it will be interesting to hear if any other pooled fund managers produce similar numbers. If they don’t , Insight may well feel that their competitors have something to hide.

Another claim which must be treated with caution was Kerrin Rosenberg’s that LDI had kept his client out of the PPF. To quote Professional Pensions

Rosenberg told the committee his firm looked at one pension fund that was worth about £1.3bn 15 years ago – doing a simulation to see how the scheme’s experience would have changed over the period had it not deployed leverage.

He said this particular scheme would have been £600m worse off today, even when taking into account the yield rises we have experienced in 2022.

Rosenberg added there was nothing unique about this particular scheme – noting the mechanics were “exactly the same” for any other defined benefit pension fund that would have been around over the last 15 years.

Kerrin was as always self-assured , charming the meeting with this beguiling vignette. Those watching and especially the  WPC will need to understand just what the investment strategy would have been had it not benefited from leveraging its bond position.

There are many pension schemes that did not adopt LDI which are now enjoying the benefit of higher yields without having to go through this year’s trauma.

The PPF’s purple book , the 2022 edition of which was published last week, shows that despite 40% of UK pension schemes not employing leveraged LDI, few schemes have claimed on the PPF. 

Who have been the winners?

Rosenberg

The economics of LDI are deeply attractive to the asset management industry, while the LDI product itself may not have a high margin, the headroom it creates for schemes to buy high margin funds that are managed for growth, makes LDI hugely attractive to firms such as Schroders (traditionally an active growth manager).

Similarly Insight is a “door to more” for BNY Mellon’s stable of active managers while Jonathan Lipkin’s Investment Association represents a range of other institutional managers whose livelihoods depend not so much on the management of fixed interest securities but of the high margin growth funds that LDI put in play. Cardano, for whom Rosenberg is UK head of investments are running a similar business model.

Collectively , the UK fund management has a dependency on LDI for its profitability. It is not making much out of DC and its core market is eroded by the “end-game” of buy-out. LDI is its way of gathering its rosebuds while it may.

Pushing back on criticisms of leverage

This is why the fund managers were at their most animated confronting criticism from the Sarah Breedon, (executive director of strategy and risk at  the Bank of England) that the crisis was caused by “poorly managed leverage”.

They really threw the kitchen sink at this allegation . Here’s Abdallah Nauphal again.

“I don’t agree that it [poorly managed leverage] was the primary cause, It was a confluence of factors that came together that created this very unique event,”

Nauphal went on to blame  the markets which he said had been “jittery” on the long-term outlook for the UK even before the “mini” Budget.

“You have a jittery market that turned into panic on rumours and then confirmation of the mini Budget. And that was a primary cause of the sell off and led to an increase in risk premia across the board.”

A second “substantially relevant” issue was how dysfunctional the gilt market had become during the crisis when small trades could move prices “very significantly”.

This explanation for the failure of leveraged LDI in September and October begs two questions

1. Why were the hedges still on when all the market pointers were towards a rapid rise in interest rates
2. Why was LDI and pooled funds in particular, so fragile that the Bank of England had to provide a £65bn safety net to stop the pooled funds eating themselves.

Insight may be able to talk a better story than others on point two, but what was the economic value lost in saving those hedges. We heard from Dalriada’s David Fogarty

“There will be losses from the selling of assets at distressed prices. The haircuts for certain assets might only be small, single percentages, but in some assets, they might be more than 15 per cent.”

The £500bn loss to the system – estimated by Keating and Clacher – takes full account of such haircuts.

What hope for the future?

The past year is not a year that anyone with assets invested in fixed interest securities will consider a good one. But can assets bounce back?

Rosenberg painted a bleak picture for the UK without leveraged LDI. Pension Schemes would have to convert growth assets to turn synthetic to real gilts, more money would be needed from sponsors to repair the damage done by forced selling and – by implication – the profitability of many asset managers would be damaged.

This of course assumes that the endgame is the only game in town. The vibe from pension schemes at the SG Conference earlier in the week was different. In one session, participating scheme managers indicated that the days of leveraged LDI were numbered and many saw a different future to buy-out.

Perhaps the Investment Association should consider the DB market through a differently than the “de-risking lens”.

What we learned

The WPC listened to three hours of heavyweight lobbying from consultants and LDI managers. During this time blame was attached to many parties but no fault was found by advisers and LDI managers in advice on or management of leveraged LDI.

For the record, here are the alleged culprits for the problems advisers and asset managers have today

1. The long dated and index-linked gilt markets which are too small to match the liabilities of UK DB schemes (the Debt Management Office)
2. The bankers who demanded unreasonable collateral to meet their margin calls
3. Trustees incapable of understanding the products they were advised to buy
4. Journalists who insist on asking the wrong questions and stirring up discontent
5. Con Keating, John Ralfe, me and Iain Clacher for demanding a ban on leverage
6. The FCA, TPR, BOE and the Treasury for regulatory overlap/underlap
7. Data managers for not making available the information that would have foretold events
8. Baroness Sharon Bowles for challenging  the received idea that the gilt rate is the means of valuing liabilities.

What we have yet to learn

There are a number of matters that trouble me

1. Just what has been the overall impact of LDI in 2022 on DB schemes?
2. How have small schemes that invested in pooled funds fared?
3. What will be the impact of LDI buffers of 3-400 bps on scheme returns?
4. How likely are advisers and trustees to want low leveraged LDI with high buffers?
5. What will emerge as the alternative asset strategy if LDI proves unviable?
6. Is there a “new environment” and if so, will the new environment be reflected in the revised regulations from the DWP due to be published any day?