Monday, October 3, 2022

LDI: Do They Ever Learn? - Or Is It Plain Old Greed?

 Remember my UK Plunge Extra post from just a few days ago? Told you so….

This blog was one of the very first to point out the risks inherent in CDS going back as early as 2007.  We know what happened afterwards.  Let’s be absolutely clear: there is ZERO fundamental need for CDS, or a plethora of other such financial market derivatives. In fact, instead of reducing risk such derivatives BY DEFINITION increase systemic risk because they introduce at least one (and frequently many more) extra counterparties to the equation: the issuer(s) of the derivative(s). Just Google “AIG CDS credit crisis” and my point becomes clear.

After the CDS meltdown in 2008-09 one would think that the market learned its lesson: Derivatives are dangerous, no matter if they dress in sheep’s clothes. But no, the lesson hasn’t been learned.

The newest culprit is called LDI, an innocuous enough strategy of Liability Driven Investing targeted mostly at corporate pension funds. As a pension fund manager you have a known future liability stream X to pay pensions, medical benefits, etc. , and current assets of Y.  Unless you work for Norway or Qatar, you have a definite mismatch problem, which ultimately boils down to this: you can’t possibly predict the far future.

Enter your friendly investment bank/pension consultant who offers you an investment strategy called LDI purporting to solve your mismatch problem.  It involves an array of derivative instruments, of course, but hey,…. It sounds good, right? Give them your money, toss the Bloomberg terminal password into the drawer and head down to the pub for a few. Problem solved.

Riiiiiiiiight….. until the (not so) unthinkable happens and a new PM decides to go for a massive unfunded tax cut and absolutely destroys the gilt market. The LDI derivatives go underwater and scream for additional margin money.  Which, of course, you don’t have unless you sell gilts or other such in order to raise cash, which pushes prices down, which creates more margin calls. Same old, same old… time and again.

10 Year Gilts Collapse

Why do they come up with this stuff, you ask? Why not stick with plain old long government bonds? Wanna know the truth? Because there’s no money in it for anyone. Plain bond trading commissions are almost zero, and so is managing portfolios of such plain vanilla stuff.  But OTC derivatives are opaque and carry hefty fees and spreads. In a word, it’s greed dressed up as “innovative” finance.

Why does LDI exist in the first place? 

Regulators started requiring corporations to carry unfunded future pension liabilities on their balance sheets, first in the UK and then in the US - and properly so. Obviously, companies hate this because it destroys their valuations.  And many companies, particularly older ones, have very sizable unfunded liabilities.  Enter your friendly banker who sells you a bunch of swaps that “hedge” all or part of your liability, thus reducing or even eliminating the hit to your balance sheer. Problem with hedging with derivatives is that they may hedge the future all right,  but they require margin today, so when the doodoo hits the fan you end up getting squeezed cash-wise, today. And, of course, you counterparty risk has increased as well. 

It boils down to this: you buy a swap from BubbaBank to reduce your future liability and promise to keep such swap properly collateralized. Essentially, you have swapped your future liability for:

1. An unknown stream of margin/collateral payments today

2. Increased counterparty risk from BubbaBank

3. A hefty upfront fee, included in the price of the swap

Doesn’t sound too attractive to me but, hey, PT Barnum had something to say about it.

Not surprisingly, the LDI business is now huge, growing from zero to $4 trillion in less than 10 years, globally.  Half of this amount involves UK pensions alone, ie a whopping 65% of UK GDP. Explains the gilt and sterling disaster last week, doesn’t it? It also explains why Truss & Co today backtracked on their I Love Maggie tax cuts. (Note: it’s a tiny backtrack, it involves only 2 billion out of a 45 billion program).

This episode of Greed Is Good is very far from over, I think. Stay tuned.


  1. I disagree with Krugman on a lot of things... but on this I agree...

    or in the words of our good friend hell... it is an uninvestable universe. The age of making money with money is over...

    1. add a qualification... I think real interest rates will remain low / go lower. If inflation is 10% and the interest rate is 6%, the real interest rate is -4%.

      Krugman does not differentiate between nominal and real interest rates in his article... but reading between the lines, it applies only to real rates.

    2. Thank you for the Krugman article AKOC! I believe Krugman is mistaken on inflation. In my opinion, the largest factor by far for low inflation until recently is/was China and its behemoth manufacturing capacity for ultra cheap goods. If, in fact, you strip out the China effect, underlying inflation is much higher. Just take a look at a "neutral" item like college tuition in the US: it rose FIVE TIMES FASTER than headline CPI.

    3. As with everything capitalist, it's only cheap when you export the cost somewhere else.

  2. Hey Hell!... glad to have piqued your interest.... =)

    Okie... let me try to rewrite Krugman.

    Basically, he argues that the natural interest rate is affected by population growth and technology advancement, neither of which is occurring. His empirical inflation based example is bad; on this I agree with Hell. However, if you observe that real interest rates are low and still falling, he seems quite right.

    This way of thinking also helps explain Hell's un-investible universe idea; it also explains the recent tech bubbles. There have been bubbles in the past; but these were based on real technology. The current tech bubbles are based on nothing. This is largely because there is no new tech. Thus, the pipelines meant to fund tech are now funding nonsense... The U.S. tech infrastructure is like a church from which god has left...

  3. Krugman on inflation: Agree with Hell. Krugman knows inflation is a problem and is lying (on that topic). Thus, when you read him, you have to actively read between the lines.

    For example, he goes on and on about how oil prices are naturally volatile and look now they are dropping, lets not worry about them.... when he knows full well that they are down because the U.S. is selling its strategic reserve.

    There was also the other case where Krugman misread a high school graph repeatedly...

  4. camabron... quite agree that Mexicans will see the U.S. in that light. Everything beautiful requires great sacrifice... preferably, the sacrifice should be paid for by someone else... =)

  5. Krugman is politically well left of center. Given current US politics he HAS to try to explain why inflation should not be worrying. After all, it's just a month until crucial elections...

    1. from a strategic point of view, I am not sure it is in the Dem's interest to try so hard to win this election... there is going to be a shit-storm soon... if the Dem's win, they will get the blame later... if they lose, at least they can blame the Republicans...

      In summary, a mid-term win may be the perfect setup for Trump's reelection..