THE PENSION RISK CYCLE
The pension risk cycle shows the interplay between risk factors that critically affect a pension plan’s value: interest rate risk -> leverage risk -> collateral risk -> liquidity risk.
Any one of the risk factors can trigger an adverse risk cycle, putting the fund itself at risk.
In our current market (2023) the pension risk cycle is most likely to be triggered by interest rate risk. This is because we have lived 10 years or more in a zero-interest rate environment. As a result, hedge funds, PE funds and other alternatives have built an edifice of leverage, collateral and liquidity based on zero (or very low) interest rates. When interest rates are low all the othe risk factors get built into a fund model as if interest rates will always remain low. This meant:
– leverage limits did not account for higher interest rates;
– liquidity needs did not account for higher interest rates;
– collateral for trading and treasury functions became inadequate in the face of higher rates.
When a fund is exposed to this risk cycle, it will inevitably show cracks and sustain damage–whether a pension fund, a hedge fund, a PE fund, or a bank. Both recent financial collapses have been initially triggered by miscalculation of interest rate risk: Silicon Valley Bank (2023) and UK Pensions (2022). On the horizon in 2023 is (likely) a Credit Suisse collapse. in our recent past was the repo market near-collapse (2019).
SILICON VALLEY BANK COLLAPSE - 2023
It appears the trigger for the SIBV collapse was a sizeable transfer in 2021 of liquid securities (“available-for-sale”) assets to illiquid securities (“hold-to-maturity”) assets in 2021. This asset shift from liquid to illiquid took place just before interest rate tightening began in 2022. At the same time in 2022, SIVB’s depositors began drawing down deposits to meet their own operational demands.
While banks are expected to maintain enough liquidity to meet foreseeable demands by depositors, SIVB did just the opposite by transferring liquid assets to illiquid assets in 2021. As a result, SIVB was unable to meet depositor’s withdraw requests through normal treasury functions, which led to depositor panic and a run on the bank.
At the heart of this SIVB problem was the bank’s “chase for yield” by opting for illiquid assets, while failing to anticipate depositor demands expected in an environment of rising interest rates that might have been meet with a larger portfolio of liquid assets.
Thus, the interest rate risk led to leverage risk and collateral risk, which led to liquidity risk. As a result, SIVB was forced to sell assets, and the rest is history.
UK PENSION COLLAPSE - 2022
In Sept. 2022 the UK government pension fund collapsed. This was triggered by the budget proposed by then prime-minister Liz Truss, which caused the UK bond (gilt) yield to sharply rise. This, in turn, caused collateral value in leveraged “liability driven investment” holdings to collapse, creating a massive liquidity problem for the pension fund.
Liability-driven-investment strategies attempt to match bond maturity dates with grouped expected retirement dates–a very sensible investing strategy, at first glance. But the LDI investments were laden with leverage–a leverage risk that increased collateral risk which ended in a liquidity blow out.
This is another example of an investing strategy that implicitly required sustained low interest rates to remain viable. But today’s volatile market, with rising interest rates, killed that strategy.
At the end of the day, the Bank of England bailed out the pension fund, infusing the fund with much-needed liquidity.
REPO MARKET COLLAPSE - 2019
The “repo market” is a form of short-term borrowing–typically overnight–using securities as collateral. The largest collateral type for repo trades is the US Treasury securities market. The largest repo traders are banks, who often need overnight borrowing to smooth short-term cash requirements inherent in the business of banking. Bank repo borrowing has been active since at least 1958.
Until Sept. 16, 2019, the repo rate of interest hovered just below 2%. In practice, this meant that hedge funds and other financial entities could borrow from repo financing sources for short term uses at a rate below 2%. But on Sept. 16, 2019, the repo rate skyrocketed to 10%–literally overnight. This created serious liquidity problems in the repo market, since fund providers suddenly were not comfortable lending money to hedge funds and other financial entities without a huge interest rate premium. This overnight jump in interest rates (from 2% to 10%) seized up the repo lending market, putting loaned funds in jeopardy.
What caused this overnight interest rate spike? Speculation centered around the then-imminent bankruptcy of the WeWork company, which threatened to collapse the global commercial real estate market, and related financial problems with WeWork’s principal investor, the Japanese hedge fund Softbank.
A FAMILIAR PATTERN
On close examination, one sees that all fund collapses are triggered by one of these risk factors: interest rate risk, leverage risk, collateral risk or liquidity risk.
In Silicon Valley Bank and the UK Pension Fund, the collapse was triggered by an unexpected spike in interest rates, where leverage was high and collateral values were compromised by long maturities of illiquid assets.
In the 2019 repo market crisis, the most likely catalyst was compromised collateral value that led to an immediate spike in interest rates. In a highly-leveraged hedge fund trades that depended on repo market for their continued existence, collateral risk led to interest rate risk, and then a liquidity crisis that threatened the entire structure of our economy.
The 2008 Great Financial Crisis was also triggered by a collateral risk, as counter-parties refused to accept MBS and other asset-backed securities as collateral for leveraged loans.
An overriding lesson is that its never “different this time”– emergence of a risk factor triggers the other risk factors in domino-like fashion.
Again, the concern for pension and 401k plans is that the vast majority of such plans have exposure to illiquid assets through a collective investment trust–and are therefore exposed to an accelerating pension risk cycle that will inevitably destroy pension value.
Pension fund managers should immediately eliminate exposure to illiquid assets in a fund–or at the very least, should clearly inform pension participants of inherent risks of these investments in a climate of rising interest rates.
Whether the Federal Reserve fully appreciates the impact its increased interest rates has on the risk cycle is an open question. But there is little doubt that interest rate risk will filter through the economy–landing with hedge funds and private equity funds who depend on low interest rates to maintain their very existence. It is only a matter of time until these exposures become evident.
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