ChrisNix wrote:Nimrod103 wrote:dealtn wrote:Dod101 wrote:OK my take on this is that pension funds have found this brilliant(!) new way to make up shortfalls in their funding or, to put it another way, to claim that they are fully funded, they just borrow by buying gilts via derivatives. In a nice calm everyday market, they need to put up a margin, call it an insurance premium , of something like say 3% of the total trade value. They pay that 3% in cash (£3,000) and can buy £100,000 of gilts to fund the 'gap'.
Then along came the mini budget and suddenly people began to question where the money was coming from, well, Government borrowing of course. That was perceived by the markets as likely to downgrade the UK's credit standing and so gilt borrowing rates were going to have to rise and derivative traders wanted instead of say 3% margin, something like say 6% ( I am making up these rates) That meant the derivative traders require cash paid on the nail representing a further 3% of the trade and most pension funds did not have these sorts of funds available as 'dry powder' as some have called it, so they had no option but to sell some assets and fast. That of course drove prices even lower and so on. A fullblown liquidity crisis.
Cue the BoE to step in and buy these gilts which were being offered by the pension funds in the fire sale.
That is probably not right or I have missed something but that is as I understand it.
Dod
Margin doesn't work like that.
A Derivative contract will be entered with typically no cost. Often there is no initial margin, but sometimes there is, and the contract's movement in price will drive the required cash (or collateral) payments.
Consider a bet on a football match on the number of goals. An average game has 2 goals. You and I decide to have a bet and you want to be paid out on the number of goals risking £100 a goal, expecting more than 2. Depending on whether an initial margin is required you might pay me a small amount say 1/2 a goal up front. Given it is low risk though and we are both "good" counterparties with excellent credit ratings I may agree I don't need any margin. The maximum you will owe me is a 0-0 draw meaning I need £200.
At kick-off the score is 0-0 and the longer the game goes on without a goal the more likely it will be you owe me money at the end of the game, so the expected goals falls (as time runs out). If the game was being margined I would expect every couple of minutes you to have to pay me £1 to compensate me for the risk you are likely to owe me £200 in 90 minutes (or now less). Similarly if a goal was scored I would (rapidly) pay you £100 ish as the value of the bet moves, in this case dramatically. If at half time the score was 4-2 you would be guaranteed at least £400 (6 less the bets strike of 2), so would in a margined world at least expect to receive £400 from me (probably more). This continues through the 90 minutes until the bet finishes when instead of me paying the full amount of £900 (the final score being 6-5 !!) I will only pay a small residue since the margin calls every minute had delivered the winnings to you over the life of the game.
Now consider the same process, but not over 90 minutes, but over 30 years, and one where the score can go both ways. Noone would enter into a 30 year contract without a margin to adjust for the current market price (or match score). Who knows if you will be alive in 30 years, or what your financial health will be to honour that bet. Margin is normal.
Now consider a short period in time in that 30 year bet, such as a day or so when our bet which is effectively the change in price from expected of a price of a gIlt moves dramatically. The Gilts expected price is say £150 in 30 years, but with (future) interest rates repriced to the market to say £50 the margin call is huge. If I had taken the bet in the football analogy (cricket runs is probably a better example!) when in the first minute 5 goals were scored I would face a massive and unexpected margin call.
Most DB pension funds though would be profit up on the markets move. They are under hedged. The value of their liabilities (the current discounted valuation of all their expected pension payments) has fallen significantly more than the fall in values of the assets (Gilts and LDI contracts). Their immediate cash needs are (massively) increased though. The pension payments are in the future - so don't affect cash now. the margin calls are immediate though. How to raise immediate cash? Sell assets, even with regret, at bad prices in the most liquid markets.
I realise this is all beyond my understanding, but why is the BoE giving such a short deadline to pension funds to sort themselves out byFriday? What could they ‘sort out’ over such a short time frame? If the BoE wants to stabilise things it must say ‘whatever it takes, for however long’, surely?
It seems the Bank of England has concerns that pension schemes were dragging their feet rather than realising assets to pay margins and generate dry powder, and/or reducing their LDI bets.
The problem is that if global long term rates rise another 1% there is plenty more still to come.
https://www.reuters.com/world/uk/britis ... 022-10-12/