Pension funds have found themselves embroiled in a byzantine world of exotic financial trading that many of them appear to have badly misunderstood.
On Tuesday, a third rescue mission in little more than a fortnight was announced by the Bank of England, which is reprising its role in the 2008 financial crisis as the City’s lifeboat.
Officials said they would widen the scope of an emergency bond-buying to include £5bn of index-linked bonds, alongside the purchase of up to £65bn worth of conventional government bonds targeted in the first two rescue missions. The intervention was about shoring up pension funds, which had been selling government bonds in order to meet demands for cash from their lenders.
Echoing its own words from two weeks ago, the Bank warned that “dysfunction” in the bond market was a material risk to the financial stability of the UK economy.
The pension funds turning to the Bank for help are those which hold gold-plated final salary schemes, under which employers are obliged to make up any shortfall between what members are entitled to on retirement and the amount of cash available from investments. These funds bought liability-driven investing (LDI) schemes from banks and investment firms to hedge their exposure to retirement payments over the next 30 years, and also to release some spare funds to gamble on riskier equities and property.
After the panic caused by the mini-budget, the core assets owned by pension schemes – UK government bonds – collapsed in value, triggering a cascade of bond sales to shore up promises made to LDI providers to make up any shortfalls beyond a certain level.
The Bank of England created a £65bn facility to act as the buyer of last resort. A week later it let the world know it had only used a fraction of his facility to calm jittery nerves in financial markets. The value of government bonds began to increase. All was well.
On Monday, events took a turn for the worse. It seems that an attempt to outsource some of the lifeboat scheme fell flat after the commercial banks entrusted with the job were unable to step in as central bank officials expected. The market was about to seize up again without further intervention.
It is often said City regulations and City regulators tend to focus on institutions that failed in the last crisis, blinkered to the ones likely to cause the next. This pensions hedging crisis is a case in point.
Back in 2014, former Bank of England chief economist Andy Haldane described the period after the financial crash in 2008.
“One of the likely consequences of the crisis, and the resulting regulatory response, is that the financial system will reinvent itself,” said Haldane, now chief executive of the Royal Society of Arts.
“Financial activity will migrate outside the banking system. And with that move, risk may itself change shape and form.
“What previously had been credit and maturity mismatch risk on the balance sheet of the banking system may metastasize into market and illiquidity risk on the balance sheets of non-banks.
“This could have important implications for the stability of the financial system and the broader economy.”
Most analysts have accused Kwasi Kwarteng of triggering the chaos with his mini-budget. But investors have also been spooked by the Bank of England’s attempts to go back to a more normal world – one where it stops printing money through quantitative easing, a mainstay of economic policy since the financial crisis, and prepares to sell back to investors much of the government debt it has bought.
The markets are spooked because the Bank has delayed the start of a programme to sell £100bn of government bonds, but not withdrawn it. Winding back quantitative easing would mean the Bank is both buying government bonds – to help pension funds – and selling them.
Threadneedle Street expects to end this obvious contradiction on Friday when the pensions lifeboat ends. Sadly that might not be the end of the story, adding another embarrassing episode to British financial history. Until the regulators seek out risk wherever they find it, these financial blow-ups are going to continue.
