Saturday, October 8, 2022

More On The Liability Driven Investment (LDI) Disaster

 In a recent post I went over the collapse of the UK gilt market and what caused it. Though the proximate cause was the announcement of massive unfunded tax cuts for the rich by the new, UNELECTED government of Thatcherite Liz Truss, the astonishing rapidity of the drop was due to yet another instance of acronym derivative folly, margin calls and forced collateral liquidation. In other words, a textbook crash that came within hours - literally - of causing pension fund disaster.

Ten Year UK Government Bonds (Gilts)

The innocuously named Liability Driven Investment (LDI) strategy is nothing more than a scheme to profit from fat fees and hidden spreads.  A Guardian article mentions LDI, in passing, as a cause for the bond massacre, but does not go into depth because a) the popular newspaper is probably not editorially equipped to do so and, b) it has more politically driven priorities, ie to bash Tory policies.

(The Financial Times, however, is certainly equipped to handle financial market analysis and has just published an article on LDI, albeit by a guest writer in its Alphaville section  - which once honorably mentioned this blog, back in the day 😏).

The Bank of England had to step in to forestall the immediate collapse of £1.5 trillion worth of pension funds using LDI, promising to buy £65 billion in gilts. It has averted the disaster for now, but the problem has not gone away. Even a cursory look at the chart above reveals that bond investors are now carrying massive mark-to-market losses created in mere days. 

The LDI “strategy” is based on long term derivatives (interest rate swaps) collateralized with long term gilts, and are definitely still very deep in the red.  All that BOE did was to step in temporarily as buyer in a market awash in supply, when other buyers (eg market makers) stepped away from the falling knife.  But even a central bank does not have unlimited buying power, unless it is willing to monetize huge amounts of debt by excessively bloating its balance sheet (aka print inflationary currency). And huge it would have to be: the £1.5 trillion of LDI nonsense amounts to 70% of UK GDP.

The problem has not gone away, it is merely averted - for now. Why just for now? Because the UK has just joined the 100% Club of nations whose public debt matches or exceeds the size of their economy (100% of GDP).  This dubious membership makes debt servicing and refinancing difficult, particularly when interest rates rise as they are doing now.

Looking past the LDI mess, the UK has a serious debt problem and the market knows it. Once again, it is  the Bond Vigilantes who have spoken clearly: Mrs. Truss you are playing with fire.


  1. on a lighter note: =)