EVERYTHING YOU WANTED TO KNOW ABOUT BRITAIN'S LDI CRISIS

5 November 2022

https://www.ft.com/content/f4a728a5-0179-48bd-b292-f48e30f8603c

Far as I can ever work out, that film "Margin Call" didn't really tell the whole story of the Sub Prime crisis. The scam was bigger than portrayed in the film. To understand it it is necessary to understand how the bond markets work and how they are the absolute core of the entire financial system - any problems in bond markets and the financial system teeters on the brink of collapse. That's exactly what happened with the subprime, Lehman went bankrupt and if the Fed hadnt bailed out the banking system, the whole economy, the whole world economy, would have collapsed. 

And that's what happened again with the LDI crisis in the UK.

So today let's take a look at both of those events : one back in 2008, the subprime crisis that provoked the Great Financial Crisis; and the other UK PM Truss' mini-budget crisis in September 2022.

SUB PRIME CRISIS

Freddie Mae and Fannie Mac were setup many decades ago in America to help Americans acquire their own homes. Private sector mortgage companies were issuing mortgages and then Freddie May would come along and buy these mortgages and would take on the responsibility for collecting the interest and capital repayments. The private sector companies with the profit they made from these were supposed to issue more mortgages. So far, so good.

But then the trouble started, as I recall, under President Clinton, who wanted to get the support of the poor by making mortgages easier to obtain. Thus, Freddie and Fannie were encouraged to encourage - with government underwriting, private sector lenders - to lend to people who would never have had sufficient credit score to borrow on their own honest record. These were sub prime risk people.

Then Freddy and Fanny were wrapping these mortgages up into a kind of fund and selling parts (shares) in the funds to mainly European banks, who sold them on to their customers. 

Maybe I'm not getting things quite right, but as I understood things, the next step was that these funds - mortgage backed securities, MBS - which were just a big bag of individual mortgages, were then sorted and grouped into tranches, tranche A, tranche B and so on, according to perceived lender risk on each mortgage; and an insurance against default was slapped on top. These very sophisticated assets are called collateralised debt obligations, CDOs, and the banks could buy shares of different risk tranches at different prices, and use these assets - now marked to market - as collateral for various leveraged operations of their own (hence the name of the film, as lenders require a certain loan-to-value, LtV, percentage and if the value of the asset drops, then the borrower is called upon to to restore, or top up, his collateral margin to the required LtV level) on behalf of their clients.

This was not so good, because it turns out that the risks were assessed using a completely felonius method and furthermore the insurance slapped on top turned out to be worthless as well. All because these funds had been calibrated according to assessed risk, but now the risk exceeded the min-max expectation as the mortgagees were not the people described in the application forms. "Liar loans", they called it.

The film Margin Call tells the story of how an imaginary bank (not dissimilar to Lehman) collected these mortgage-backed securities into the CDOs, which it then sold on to its clients. Important to note at this point that the repackaging process took some time, possibly a month according to the film, during which processing time the bank held these assets and could become victim of a markdown because high delinquency levels, and subsequent margin call. What if it didn't have the money to top-up its collateral?

The problem was that the time it took them to parcel up and sell on, which ie was the time they were holding these assets, and it turned out that the scam of accepting these "liar loans" in the subprime market was being discovered and once "outed", could devalue by at least a quarter and possibly a half, the value of these bank assets. If so, this would leave the bank bankrupt as it's borrowing, its liabilities, would then far exceed its assets.

Well, the bottom did fall out of the mortgage market when it was realised that large percentages of these mortgages were money lent to hopeless cases.

But how the guys in the imaginary bank in the film managed to shift all that CDO in the space of 24 hours is totally amazing and that's what the film is all about. Lehman didn't manage it and Lehman quite rightly went under. This film rewrites the story and the bank shifts all its "shity assets CDOs".

That is the extent of my (possible mis)understanding, I might have got things a little mixed up, feel free to correct me in the comments, I don't know, but Lehman went bankrupt, collapsed and triggered the most awful financial crisis whose unresolved consequences we live with today.

MINI BUDGET CRISIS

And so this film Margin Call, made in 2011, is particularly relevant today, because on September 23 the UK experienced a crisis in its bond market, triggered not by subprime lending but by Liability Driven Investment strategies (LDI).

Again, as I understand it, what this crisis was about was the defined pension benefit guarantees, DB Schemes. In the low interest rate climate resulting from the subprime crisis, the pension companies found themselves unable to match their future fixed liabilities, year on year, to their pensioners. 

The expected result from high delinquency in the massive mortgage market was frozen interbank lending, bailout by Paul Volcker, consequent QE money printing to lower interest rates and raise asset values (for those with assets), that would ultimately materialise into high inflation as demand chases supply into inflation, and possibly despite raised interest rates, a currency collapse and recession ...we await that.

The pension companies' liabilities to pensioners can easily be calculated, year on year, that is not the problem. It is matching those liabilities to the pension companies income streams in a low interest rate environment that is the problem. Traditionally, the company would assure its liabilities from interest payments on government bonds, known in the UK as gilts (the paper certificates once had a gilt border to insist that this was a rock solid, risk-free loan to the UK government).

 Guarateed pensions maybe, but in the low interest rates we've had for many years, pension companies couldn't match to their liabilities and they turned to riskier assets, like shares or non-govt bonds, and derivatives; and for reasons of security, ironically, they leveraged trades and as leverage means borrowing, they hedged against big moves in interest rates using swaps and options.

A leveraged trade is a trade made with money that you have borrowed against your assets. Now here's the thing ...

Truss announced unfunded tax cuts of 45b GBP that put the willies up the bond markets. The bond market "vigilantes" (so-called because they are vigilant as to the rates of return on the money they lend) don't have to accept BOE interest rates, they can hold the Bank of England to ransom by refusing to lend at rates rates they consider are not commensurate with the risk of weakening the currency in which they will be repaid. 

Lenders were not prepared to lend money any longer at those old rates, given the impending disaster to the economy from these unfunded cuts, on inflation and the value of the currency.

Ie, lenders pushed up rates at which they were prepared to lend, and therefore pushed down the value of bonds themselves. 

But these bond assets were the collateral that the pension funds were using to support their leveraged deals and when the value of the assets went down the insurers, such as Legal & General, were not prepared to underwrite at that level of risk. They demanded that the pension funds top up the value of their collateral, i.e. restore the margin of of loan to value, which obliged pension schemes to sell their bonds to raise cash and that, reducing demand, in a particularly vicious circle, pushed down bond prices and thus upped gilt yields still more.

So that in the space of just three days, the 30-year gilt put on 1.4%, which is quite extraordinary.

Interest rates determine the absolute amount the government must pay to service its debt, so more interest to pay means more borrowing, but also business lives off debt for investment purposes (let's say) and their rollover rates would have increased quite dramatically, pushing the UK economy even faster into recession.

So in what is seen by many as a coup to remove the PM and her Chancellor for pursuing policies unacceptable to the markets and ruling elite, the governor of the Bank of England was forced to buy up the mortgages of these pension funds in order that they could meet their margin calls.

The PM and her chancellor were sacked and replacements brought in returned government policy to austerity and markets to calm.

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