Tag: leverage

Capital regulation and the Treasury market

Mary Pat Campbell

Link: https://www.brookings.edu/research/capital-regulation-and-the-treasury-market/

PDF: https://www.brookings.edu/wp-content/uploads/2023/03/Brookings-Tarullo-Capital-Regulation-and-Treasuries_3.17.23.pdf

Excerpt:

The dramatic, though short-lived, disruption of the market for U.S. Treasury debt in September 2019 and the more profound market dislocations at the onset of the COVID crisis in March 2020 have raised the issue of whether the treatment of central bank reserves and sovereign debt in bank capital requirements exacerbated the problems. Changes have been proposed to the Enhanced Supplementary Leverage Ratio (eSLR) and G-SIB (Global Systemically Important Bank) capital surcharge, both of which apply only to the eight U.S. banks designated as globally significant. Because these banks are some of the most important dealers in U.S. Treasuries, regulatory disincentives to hold and trade Treasuries can adversely affect the liquidity of the world’s most important debt market.

Disagreement over whether to adjust the eSLR, the surcharge or both is often just a version of the continuing debate over the right level of required capital. Some banking interests seize on episodes of Treasury market dysfunction to argue for reductions in the eSLR and surcharge. Some regulators, elected representatives, and commentators see any adjustments as weakening post-Global Financial Crisis (GFC) capital standards. Yet it is possible to reduce the current regulatory disincentive of banks, especially at the margin, to hold and trade Treasuries without diminishing the overall capital resiliency of large banks.

The concern with eSLR is that when it is effectively the binding regulatory capital constraint on a bank, that institution will limit its holding and trading of Treasuries. The eSLR can be modified to accommodate considerably more intermediation of Treasuries without significantly undercutting its regulatory rationale. As for the G-SIB surcharge, there are some unproblematic changes that could help.  But the chief complaints from banks about the G-SIB surcharge will be harder to satisfy without undermining the rationale of imposing higher capital requirements on systemically important banks.

Even with a change in the eSLR, banks’ holdings of Treasuries would continue to be subject to capital requirements for market risk. Moreover, as the failure of Silicon Valley Bank has demonstrated, the exclusion of unrealized gains and losses on banks’ available-for-sale portfolio of debt securities, including Treasuries, can give a misleading picture of a bank’s capital position. Following the Federal Reserve’s 2019 regulatory changes, only banks with more than $700 billion in assets or more than $75 billion in cross-jurisdictional activity are required to reflect unrecognized gains and losses in their capital calculations. The banking agencies should consider a significant reduction in these thresholds.

Far-reaching deregulatory changes would not remedy all that is worrisome in Treasury markets today. As the studies cited in the full paper emphasize, a multi-pronged program is needed. In any case, it would be misguided to seek greater bank capacity for Treasury intermediation at the cost of undermining the increased resiliency of the most important U.S. banking organizations or international bank regulatory arrangements. At the same time, it would be ill-advised not to recognize the changes in Treasury markets, beginning with their increased size because of fiscal policy. The modifications of capital regulation, especially the eSLR, outlined in the paper should ease (though not eliminate) constraints on banks holding and trading Treasuries without endangering the foundations of the post-GFC reforms.

Author(s): Daniel K. Tarullo

Publication Date: 17 Mar 2023

Publication Site: Brookings

Why private equity sees life and annuities as an enticing form of permanent capital

Mary Pat Campbell

Link: https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-private-equity-sees-life-and-annuities-as-an-enticing-form-of-permanent-capital

Graphic:

Excerpt:

Once they’ve acquired a book, firms can turn their attention to driving value. Building on our guidelines for closed-book value creation, owners have six levers that can collectively improve ROE by up to four to seven percentage points (exhibit):

  • Investment performance: optimization of the SAA and delivery of alpha within the SAA
  • Capital efficiency: optimization of balance-sheet exposures—for example, active management of duration gaps
  • Operations/IT improvement: reduction of operational costs through simplification and modernization
  • Technical excellence: improvement of profitability through price adjustments, such as reduced surplus sharing
  • Commercial uplift: cross-selling and upselling higher-margin products
  • Franchise growth: acquiring new blocks or new distribution channels

Most PE firms view the first lever, investment performance, as the main way to create value for the insurer, as well as for themselves. This lever will grow in importance if yields and spreads continue to decline. Leading firms typically have deep skills in core investment-management areas, such as strategic asset allocation, asset/liability management, risk management, and reporting, as well as access to leading investment teams that have delivered alpha.

Capital efficiency is also well-trod ground, and for private insurers it presents a greater opportunity given their different treatment under generally accepted accounting principles, (GAAP), enabling them to apply a longer-term lens and reduce the cost of hedging. However, most firms have yet to explore the other levers—operations and IT improvement, technical excellence, commercial uplift, and franchise growth—at scale. Across all these levers, advanced analytics can enable innovative, value-creating approaches.

Author(s): Ramnath Balasubramanian, Alex D’Amico, Rajiv Dattani, and Diego Mattone

Publication Date: 2 February 2022

Publication Site: McKinsey

Why do pension schemes use liability-driven investment?

Mary Pat Campbell

Link: https://lotsmoore.co.uk/why-do-pension-schemes-use-liability-driven-investment/

Excerpt:

Liability-driven investment allows schemes to invest in the growth assets they need to close the funding gap while reducing the impact of interest rates on the liabilities. This is achieved by assigning a portion of a portfolio to an LDI fund. Rather than this fund just holding gilts, it holds a mixture of gilts and gilt repos.

A gilt repo is re-purchase agreement. The LDI manager sells a gilt to a counterparty bank while arranging to buy back that gilt at a later date for an agreed price. This gilt repurchase agreement provides cash to the pension scheme which it can then use to invest in other assets.

This mixture of gilts and gilt repos in an LDI fund uses leverage to provide capital to the pension fund. It is akin to using a mortgage to buy a house. Different levels of leverage were available in the funds – the more leverage, the greater the ratio of gilt repos to gilts in a fund.

The more leverage in a fund, the less capital a pension scheme had to lock up in government debt and the more it could use to invest in assets which could help to close its funding gap. This was helpful when interest rates were low but became problematic when gilt yields rose.

Author(s): Charlotte Moore

Publication Date: 17 Oct 2022

Publication Site: Lots Moore

Bank of England Bought Only Small Amounts of Bonds even Today, Warns Pension Funds They Have “Only Three Days Left” to Unwind Derivatives with BOE Support

Mary Pat Campbell

Link: https://wolfstreet.com/2022/10/11/bank-of-england-bought-only-small-amounts-of-bonds-even-today-warns-pension-funds-they-have-only-three-days-left-to-unwind-derivatives-with-boe-support/

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Excerpt:

The relatively puny amounts of actual purchases show that the BOE is trying to calm the waters around the gilts market enough to give the pension funds some time to unwind in a more or less orderly manner whatever portion of the £1 trillion in “liability driven investment” (LDI) funds they cannot maintain.

The small scale of the intervention also shows that the BOE is not too upset with the gilts yields that rose sharply in the run-up to the crisis, triggering the pension crisis, and have roughly remained at those levels. The 10-year gilt yield today at 4.44% was roughly unchanged from yesterday and just below the September 27 spike peak.

And it makes sense to have these kinds of yields in the UK, and it would make sense for these yields to be much higher, given that inflation has spiked to 10%, and yields have not kept up with it, nor have they caught up with it. And to fight this raging inflation, the BOE will need to maneuver those yields far higher still:

So today, BOE Governor Andrew Bailey, speaking at the Institute of International Finance annual meeting in Washington D.C., warned these pension fund managers that the BOE will only provide this level of support, however little it may be, through the end of the week, to smoothen the gilt market and give the pension funds a chance to unwind in a more or less orderly manner the portions of their LDI funds that they cannot maintain.

Author(s): Wolf Richter

Publication Date: 11 Oct 2022

Publication Site: Wolf Street

Bank of England to Treasury, House of Commons

Mary Pat Campbell

Link: https://committees.parliament.uk/publications/30136/documents/174584/default/

Graphic:

Excerpt:

LDI strategies enable DB pension funds to use leverage (i.e. to borrow) to increase their
exposure to long-term gilts, while also holding riskier and higher-yielding assets such as
equities in order to boost their returns. The LDI funds maintain a cushion between the
value of their assets and liabilities, intended to absorb any losses on the gilts. If losses
exceed this cushion, the DB pension fund investor is asked to provide additional funds
to increase it, a process known as rebalancing. This can be a more difficult process for
pooled LDI funds, in part because they manage investment from a large number of small
and medium sized DB pension funds.

Diagram 1 gives a stylised example of how the gilt market dynamics last week could
have affected a DB pension fund that was investing in an LDI fund. In this illustrative and simplified example, the left hand side of the diagram shows that the scheme is underfunded (in deficit) before any change in gilt yields, with the value of its assets lower than
the value of its liabilities. More than 20% of UK DB pension funds were in deficit in August
2022 and more than 40% were a year earlier. In this example, the fund is holding growth
assets to boost returns and has also invested in an LDI fund to increase holdings of longterm gilts, funded by repo borrowing at 2 times leverage (i.e. half of the holding of gilts in
the LDI fund is funded by borrowing). The cushion (labelled ‘capital’) is half the size of
the gilt holdings.

The right hand side of the diagram shows what would happen should gilt yields rise (and
gilt prices fall). The value of the gilts that are held in the LDI fund falls, in this example by
around 30%. This severely erodes the cushion in the LDI fund. If gilt prices fell further, it
would risk eroding the entire cushion, leaving the LDI fund with zero net asset value and
leading to default on the repo borrowing. This would mean the bank counterparty would
take ownership of the gilts. It should be noted that in this example, the DB pension fund
might be better off overall as a result of the increase in gilt yields. This is because the
market value of its equity and shorter-term bond holdings (‘other assets’) would not fall
by as much as the present value of its pension liabilities, as the latter are more sensitive
to long-term market interest rates. The erosion of the cushion of the LDI fund would lead the LDI fund either to sell gilts to reduce its leverage or to ask the DB pension fund
investors to provide additional funds.


In practice, the move in gilt yields last week threatened to exceed the size of the cushion
for many LDI funds, requiring them to either sell gilts into a falling market or to ask DB
pension plan trustees to raise funds to provide more capital.

Author(s): Sir John Cunliffe, Deputy Governor, Financial Stability

Publication Date: 5 Oct 2022

Publication Site: UK Parliament

U.K.’s LDI-related turmoil puts spotlight on use of derivatives

Mary Pat Campbell

Link: https://www.pionline.com/pension-funds/uks-ldi-related-turmoil-could-spread-experts-say

Graphic:

Excerpt:

The Bank of England’s emergency bond-buying last week helped shore up U.K. pension funds and threw a spotlight on a popular strategy among corporate plans known as LDI – or liability-driven investing.

Total assets in LDI strategies in the U.K. rose to almost £1.6 trillion ($1.8 trillion) at the end of 2021, quadrupling from £400 billion in 2011, according to the Investment Association, a trade group that represents U.K. managers. Many LDI mandates allow for the use of derivatives to hedge inflation and interest rate risk.

….

Here’s how LDI works: Liability-driven investing is employed by many pension funds to mitigate the risk of unfunded liabilities by matching their asset allocation and investment policy with current and expected future liabilities. The LDI portion of a pension fund’s portfolio utilizes liability-hedging strategies to reduce interest-rate risk, which could include long government and credit bonds and derivatives exposure.

Jeff Passmore, LDI solutions strategist at MetLife Investment Management, said the situation with U.K. pension plans “has been challenging, and the heavy use of derivatives in the U.K. LDI model has made the current situation worse than it would otherwise be.”

While most U.S. LDI portfolios rely on bonds rather than derivatives, ‘”those U.S. plan sponsors who have leaned heavily on derivatives and leverage should take a cautionary lesson from what we’re seeing currently across the Atlantic.”

….

The U.K. pension debacle “is a plain-and-simple problem of leverage,” Charles Van Vleet, assistant treasurer and chief investment officer at Textron, said in an email.

Many U.K. pension plans were interest rate-hedged at 70%, while also holding 60% in growth assets, suggesting 30% leverage, he said. The portfolio’s growth assets have lost around 20% of value if held in public equities and fixed income or about 5% down if held in private equity, he noted.

“Therefore, to make margin calls on their derivative rate exposure they had to sell growth assets – in some cases, selling physical-gilts to meet derivative-gilt margin calls,” Mr. Van Vleet said.

“The problem is worse for plans who gain rate exposure with leveraged ETFs. The leverage in those funds is commonly via cleared interest rate swaps. Margin calls for cleared swaps can only be met with cash – not posted collateral. Therefore, again selling physical-gilts to meet derivative-gilt margin calls.”

Author(s):

BRIAN CROCE
COURTNEY DEGEN
PALASH GHOSH
ROB KOZLOWSKI

Publication Date: 5 Oct 2022

Publication Site: Pensions & Investments

The Inevitable Financial Crisis

Mary Pat Campbell

Link: https://www.nakedcapitalism.com/2022/10/the-inevitable-financial-crisis.html

Excerpt:

For months, I have been confident that Europe would suffer a financial crisis and a depression, as in a real economy catastrophe accompanied by a market crash. It might not be as severe and lasting as 1929, but the breadth would mean there would not be 1987 quick bounceback nor a 2008 derivatives crisis concentrated at the heart of the banking system. Even though that looked like financial near-death experience, the same factors that made it more acute in many respects also made it easier for the officialdom to identify and shore up the key institutions that took hits below the water line.

….

That view was based simply on the level of damage Europe seemed determined to suffer via the effect of sanctions blowback on supplies of Russian gas. There are additional de facto and self restrictions on Russian commodities via sanctions on Russian banks and warniness about dealing with Russian ships and counterparties. For instance, Russian fertilizer is not sanctioned; indeed, the US made a point of clearing its throat a couple of months back to say so. Yet that does not solve the problem African (and likely other) buyers suffer They had accounts with now-sanctioned Russian banks and have been unable to come up with good replacement arrangements.

Another major stressor is the dollar’s moon shot. It increased the cost of oil in local currency terms, making inflation even worse. It also will produce pressure, and potentially defaults, in any foreign dollar debtor because he local currency cost of interest payments will rise. Given the generally high state of nervousness in financial markets, anyone who had been expected to roll maturing debt will be in a world of hurt (Satyajit Das in a recent post pointed out that investors typically don’t expect emerging market borrowers to repay).

….

Yet another big concern is hidden leverage, particularly from derivatives. A sudden rise in short term interest rates and increased volatility can blow up derivative counterparties. It’s already happening with European utility companies, many of whom are so badly impaired as to need bailouts.

And the failure of regulators to get tough with banks in the post-crisis period is coming home to roost. Nick Corbishley wrote about how Credit Suisse went from being a supposedly savvy risk manage to more wobbly than Deutsche Bank due to getting itself overly-enmeshed in the Archegos “family office” meltdown and then the Greensill “supply chain finance” scam. Archegos demonstrated a lack of regulatory interest in “total return swaps” which in simple terms allow speculators to create highly leveraged equity exposures. Highly leveraged equity exposures was what gave the world the 1929 crash. The very existence of this product shows the degree to which the officialdom has unlearned big and costly lessons.

Author(s): Yves Smith

Publication Date: 3 Oct 2022

Publication Site: naked capitalism

UK Pensions Got Margin Calls

Mary Pat Campbell

Link: https://www.bloomberg.com/opinion/articles/2022-09-29/uk-pensions-got-margin-calls

Excerpt:

I said above that pension funds are unusually insensitive to short-term market moves: Nobody in the pension can ask for their money back for 30 years, so if the pension fund has a bad year it won’t face withdrawals and have to dump assets. Still, pension managers are sensitive to accounting. If your job is to manage a pension, you want to go to your bosses at the end of the year and say “this pension is now 5% less underfunded than it was last year.” And if you have to instead say “this pension is now 5% more underfunded than it was last year,” you are sad and maybe fired; if the pension gets too underfunded your regulator will step in. You want to avoid that.

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

  1. You will try to beat your benchmark, buying stocks and higher-yielding bonds to try to grow the value of your assets.
  2. 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:

  1. £24 in gilts,
  2. £5 in stocks, and
  3. borrow another £24 and put that in gilts too.[5] [5] No science to this number, and you’d probably do a bit less if your stocks are correlated with rates.

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. 

This all makes total sense, in its way. But notice that you now have borrowed short-term money to buy volatile financial assets. The thing that was so good about pension funds — their structural long-termism, the fact that you can’t have a run on a pension fund: You’ve ruined that! Now, if interest rates go up (gilts go down), your bank will call you up and say “you used our money to buy assets, and the assets went down, so you need to give us some money back.” And then you have to sell a bunch of your assets — the gilts and stocks that you own — to pay off those margin calls. Through the magic of derivatives you have transformed your safe boring long-term pension fund into a risky leveraged vehicle that could get blown up by market moves.

I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.

Anyway, as I said above, 30-year UK gilt rates were about 2.5% this summer. They got to nearly 5% this week, and were at about 3.9% at 9 a.m. New York time today. You can fill in the rest.

Author(s): Matt Levine

Publication Date: 29 Sept 2022

Publication Site: Bloomberg

Ohio’s Out-of-the-Box Pension

Mary Pat Campbell

Link: https://www.toledoblade.com/opinion/editorials/2022/09/18/editorial-ohio-out-of-the-box-public-pension/stories/20220914044

Excerpt:

Alarm bells should be ringing about the Ohio Police & Fire Pension following the release of a fiduciary audit of the fund, finished six years after the legal deadline.

Ignoring the law falls on the Ohio Retirement Study Council and their creator, the Ohio General Assembly. But the warnings on investment risk within the OP&F portfolio demand immediate, widespread attention.

The combined pension contribution for police is 31.75 percent of their salary and with firefighters the employer-employee combination is 36.25 percent.

…..

Ohio Police & Fire is “clearly thinking outside the box,” according to Funston Advisory Services. “OP&F is among a very small number of major institutional investors to have adopted a risk parity investment approach across the plan’s entire investment structure,” Funston tells us. Ohio’s police and fire pension is also a pioneer in an investment strategy called “portable alpha.”

In each case, the characteristic that separates OP&F from the rest of the public pension pack is “meaningful use of portfolio leverage.” The Ohio safety forces pension is using one of the riskiest investment strategies in America. The 25 percent of leverage showing on the balance sheet is actually much higher because the alternative investments also include leverage.

The entire portfolio is managed by outside managers, 135 fund managers by our count, who pulled down “mind boggling” fees according to pension expert Richard Ennis. If Mr. Ennis’ name sounds familiar you probably remember he was the expert Ohio turned to for comprehensive analysis of the Coingate scandal at the Ohio Bureau of Workers Compensation. Mr. Ennis gave us an assessment of the OP&F performance over the last 10 years that indicates the pension matched the results of an index fund despite the high fees.

Author(s): The Blade Editorial Board

Publication Date: 18 Sept 2022

Publication Site: The Toledo Blade

Pension Funds Plunge Into Riskier Bets—Just as Markets Are Struggling

Mary Pat Campbell

Link: https://www.wsj.com/articles/pension-funds-plunge-into-riskier-betsjust-as-markets-are-struggling-11656274270

Graphic:

Excerpt:

More than 100 state, city, county and other governments borrowed for their pension funds last year, twice the highest number that did so in any prior year, according to a Municipal Market Analytics analysis of Bloomberg data. Nearly $13 billion of these pension obligation bonds were sold last year, which is more than in the prior five years combined.

The Teacher Retirement System of Texas, the U.S.’s fifth-largest public pension fund, began leveraging its investment portfolio in 2019. Next month, the largest U.S. public-worker fund, the roughly $440 billion California Public Employees’ Retirement System, known as Calpers, will add leverage for the first time in its 90-year history.

While most pension funds still avoid investing borrowed money, the use of leverage is spreading faster than ever. Just four years ago, none of the five largest pension funds used leverage.

Investing with borrowed money can juice returns when markets are rising, but make losses more severe in a down market. This year’s steep slump in financial markets will test the funds’ strategy.

It’s too soon to tell how the magnified bets are playing out in the current market, as funds won’t report second-quarter returns until later in the summer. In the first quarter, public pension funds as a whole returned a median minus 4%, according to data from the Wilshire Trust Universe Comparison Service released last month. A portfolio of 60% stocks and 40% bonds—not what funds use—returned minus 5.55% in the quarter, Wilshire said.

Author(s): Dion Rabouin, Heather Gillers

Publication Date: 26 Jun 2022

Publication Site: WSJ

Bloomberg, Other Publications Criticize CalPERS’ Leverage on Leverage Plan to Boost Returns While Missing Additional Types of Borrowing

Mary Pat Campbell

Link:https://www.nakedcapitalism.com/2021/12/bloomberg-other-publications-criticize-calpers-leverage-on-leverage-plan-to-boost-returns-while-missing-additional-types-of-borrowing.html

Graphic:

Excerpt:

The financial press has gone into a round of hand-wringing over CalPERS’ efforts to chase higher returns in a systematically low-return market, now by planning to borrow at the CalPERS level on top of the leverage employed in many of its investment strategies, in particular private equity and real estate.

These normally deferential publications are correct to be worried. Not only is this sort of leverage on leverage dangerous because it can generate meltdowns and fire sales, amplifying damage and potentially creating systemic stresses, but the debt picture at CalPERS is even worse than these accounts they depicted. They failed to factor in yet another layer of borrowing at private equity funds and some real estate funds called subscription line financing, which we’ll describe shortly.

…..

CalPERS tells other less obvious fibs, such as trying to depict private equity as so critical to success that it need to put more money on that number on the roulette wheel. Remember, the name of the game in investment-land isn’t absolute performance but risk adjusted performance. Not only has private equity not generated the additional returns to compensate for its extra risk at least as long as we’ve been kicking those tires (since 2012), academic experts such as Ludovic Phalippou, Richard Ennis and Eileen Appelbaum have concluded private equity has not even beaten stocks since the financial crisis.

Let us stress that unlike German investors, who have a pretty good handle on all the leverage bets in their investment portfolios and thus can make a solid estimate of how much risk they are adding via borrowing across all their investments, CalPERS is flying blind with respect to private equity. It does not have access to the balance sheets of the portfolio companies in its various private equity funds.

And while having balance sheet would be a considerable improvement over what is has now, it doesn’t give the whole picture. CalPERS would also need to factor in operating leverage. When I was a kid at Goldman, whenever we analyzed leverage (as in all the time), we had to dig into the footnotes of financial statements, find out the amount of operating lease payments, and capitalize them, as in gross up the annual lease payments to an equivalent amount of borrowing so we could look at different companies on a more comparable basis.

Author(s): Yves Smith

Publication Date: 10 Dec 2021

Publication Site: naked capitalism