The 2022 Run on the Pension Funds: Tales from TradFi

While everyone with some exposure to the collapse of Celsius and Voyager is now familiar with the concept of a bank run and how that looks, bank runs in the realm of traditional finance are somewhat rarer events. This week, however, saw a major run-type event take place in the U.K. Several features of this story are, I suggest, highly relevant to the Reserve project:

  1. The run was precipitated by a “black swan” type event (somehow, though, these always seem to happen just a bit more frequently than you would think)

  2. The story involves a spiral where values of a key asset unexpectedly crashed, alongside the value of the collateral meant to protect one counterparty to a major trade.

Over at Bloomberg, Matt Levine has a terrific, layman-friendly explanation of the “bank run” on UK pension funds that took place this week, culminating in the Bank of England’s intervention in the gilt markets on Wednesday that put a stop to the panic just before it was about to escalate to Lehman-Brothers-breaking-the-buck-of-money-market-funds levels of disaster (“gilts”, by the way, are just financial market slang for UK government bonds). I excerpt the most important bits here, but thoroughly encourage everyone to read the whole thing, especially since you might well be asking the most obvious question: how the heck can there be a run on pension funds?

“…But once you move beyond the simple case this gets worse. Let’s say you have to pay £100 of benefits in 30 years, and you plan to pay for that using half bonds (gilts worth £24 today) and half stocks (stocks worth £5 today). If gilts yield 2.5% and stocks return 8% per year for 30 years, that will give you £100 in 30 years, enough to pay those benefits. But today, you have assets of £29 (£24 of gilts and £5 of stocks), and liabilities of £48 (the present value of that £100 pension obligation in 30 years at a 2.5% discount rate). So your pension is underfunded, by £19. It happens! It might be fine, if you get the returns you want. But it could make you nervous. One way to overcome this nervousness is to invest in even riskier assets with higher returns, so that next year you have, you know, £33, and are less underfunded….

The bigger problem is what happens when interest rates change. Again, say that the interest rate on 30-year gilts falls to 2%. Now you have £55 of liabilities (the present value of your pension obligations discounted at 2%). The value of your gilt holdings has gone up to £27.50 as rates fell. The value of your stock holdings might not have, though; stocks don’t move automatically with interest rates. Still, let’s say that your stocks have gone up, by 20%, to £6. Now you have £55 of liabilities and £33.50 of assets. You are underfunded by £21.50 instead of £19, which is worse. You have “lost money,” in a very accounting-fiction-y sense. Your actual pension obligations (how much you need to pay in 30 years) have stayed the same, and the market value of your assets has gone up. But your accounting statements show that you have lost money.

Notice that what this means is that, on a reasonable set of assumptions, pensions are short gilts: They lose money (in an accounting sense) whenever interest rates go down (and gilt prices rise), and they make money (in an accounting sense) whenever interest rates go up (and gilt prices go down).[4] Notice also how counterintuitive this is: In its simplest form, a pension fund just is a pile of gilts. The basic default move for a pension manager is to take a bunch of money and put it in gilts. Intuitively, she is long gilts: She has a pile of government bonds, and as rates go down the value of her holdings goes up. But as long as she doesn’t put all of it in gilts, and as long as the pension is underfunded, then she is as an accounting matter short gilts….

And so the way you will approach your job is something like:

You will try to beat your benchmark, buying stocks and higher-yielding bonds to try to grow the value of your assets.

You will hedge the risk of rates going down. If rates go down, your liabilities will rise (faster than your assets); you are short gilts. You want to do something to minimize this risk.

The way to do that hedging is basically to get really long gilts in a leveraged way. If you have £29 of assets, you might invest them like this:

£24 in gilts,

£5 in stocks, and

borrow another £24 and put that in gilts too.[5]

That way, if rates go down, the value of your portfolio goes up to match the increasing value of your liabilities. So you are hedged. You were short gilts, as an accounting matter, and you’ve solved that by borrowing money to buy more gilts. In practice, the way you have borrowed this money is probably not by actually getting a loan and buying gilts but by doing some sort of derivative (interest-rate swap, etc.) with a bank, where the bank pays you if rates go down and you pay the bank if rates go up. And you have posted some collateral with the bank, and as interest rates move up or down you post more or less collateral.”

The immediate cause of the crisis was a fiscally expansionary UK government budget, announced by the incoming Truss administration, that surprised markets with its unfunded tax cuts. Consequently, markets reacted by selling off UK government bonds, causing yields on those bonds to rise and the value of the bonds to fall. The degree of the volatility spike was really extreme, as the following graphic shows:

It’s worth reiterating here, by the way, that bond yields are the inverse of bond prices. The simplest way to think about this is that if people don’t want to buy your debt, the market value of the debt is worth less, and you’ll have to offer a higher yield to get people to buy it at all.

Now, the other thing that matters here is the nature of the collateral that the pension funds had posted with the banks in order to get this long leveraged exposure to gilts. The collateral was, it turns out…gilts! On one level, this makes sense. Gilts are just about the safest assets that a pension fund is likely to own. On the other hand, it’s also moderately insane. You’ve leveraged yourself to go long an asset, and your collateral for this trade is….more of that asset?

What happened next should be easy to understand (if it’s not at this point, do read Levine’s piece again). Bond prices fell and yields spiked by far more than the pension funds’ risk models had predicted. The banks call them up asking to post more collateral, since the value of the collateral pledged so far has fallen by a lot. They can only do so, at this point, by liquidating more assets. Usually you would liquidate your most liquid assets first, like…gilts. Except that the gilt market is collapsing and liquidity is drying up since no one wants to buy an asset falling in value so quickly. The pension funds were facing the prospect of seeing all their collateral wiped out and forced liquidations of other assets like stocks and corporate debt, bringing into view the exciting prospect of much wider financial market contagion. Unsurprisingly, the central bank at this point announced that it would temporarily buy as many gilts as were necessary to drive down yields and stop the death spiral that the pension funds were trapped in.

What should we learn from this? I suggest three main takeaways:

  1. Over a long enough timescale, pretty much every financial institution will try to turn itself into a shadow bank, since borrowing short-term cheap money to buy long-term valuable assets is just such a good business if you can make it work.

  2. Every financial institution that has become a quasi-bank is more vulnerable to bank runs than it thinks.

  3. When trying to hedge yourself against unexpected volatility in asset values, you really really don’t want your insurance/collateral to be either a) the same as the asset in question or b) highly correlated with the performance of that asset class. These death spiral dynamics are virtually impossible to escape from absent an external intervention, once the forced selling begins. I invite you to imagine, for example, what would happen to the value of all volatile cryptoassets (RSR included) in the immediate aftermath of the unexpected depeg of a major stablecoin.