Can someone explain in laymans terms what is happening with the BOE/pension funds on Friday?

[Silverin]

There seems to be a lot of panicked talk in the financial media about pension funds potentially collapsing and the BOE needing to step in to help them but this support being stopped on Friday.

As a layperson, I would like to understand what is going on - what are gilts, what did the BOE do/not do and what are the risks to pension funds that could cause a collapse on Friday?

[PrincessIce]

Gilts
In order to pay for things the Government has to borrow money - it does this by issuing bonds (which is essentially a loan but instead of a loan agreement with a specific bank, it is a piece of paper promising whoever owns the piece of paper it will pay them a fixed amount of interest over a fixed period of time and then at the end of the time return the original amount). Bonds are used by companies and Governments to borrow money from "the market", i.e. a range of investors rather than just a specific loan arrangement with a bank or banks.

A UK Government bond is called a Gilt.

[FlibbertyGiblets]

I don't know either. My mates are posting on twitter/facebook along the lines of 'uh-oh now, here we go, hold on tight' but tbh I get more sense looking at Olive and Mabel vids.

[Vinniepolis]

My understanding is: a lot of defined benefit pension funds use an investment called LDI where they buy gilts, then sometimes they use those gilts to borrow money to buy more gilts - sometimes a few times over. When the value of gilts fall, the pension funds have to stump up more money as collateral for those loans - so they sell off gilts, which drives down the price of gilts further etc, so they could end up in a death spiral and have to sell everything ie go bust. Frany the investment advisers should all be sacked or sued - they have promoted gilts as a failsafe low-risk investment to pension fund trustees, but failing to mention that this all works as long as interest rates stay unrealiistically low… Not all pension funds are affected - the ones that haven’t used LDI irresponsibly are actually in a better position overall.

[PrincessIce]

The Government's mini budget basically told the market that it was going to need to borrow an extra £45bn with no explanation of how it was going to pay it back.

It was the equivalent of someone who was already in living their overdraft declaring they'd just got a new credit card and were going to whack £25k on it but with no real explanation of how they were going to afford the repayments.

The extra spending would also increase inflation, which is already high.

This means that interest rates go up.

[1jan2020]

What I would love to know is - will all this affect interest rates and therefore mortgage rates?

[PrincessIce]

When interest rates go up the value of gilts goes down. Because they are a promise to pay say 2% interest - nobody wants them when they know they can get 4% interest. So the value goes down and no one wants them.

The Bank of England stepped in and started buying th Gilts no one wants.

The movements seen in the market haven't been seen since the 1990's.

Vinniepolis has explained it better than me!

[Moonwalkingagain]

What I dont understand is what happens to Investor money if those Funds collapse? Will there be large numbers of people whose Pension investments are lost?

And what about Pensions already being paid out? Will there be Pensioners who suddenly no longer have the Pension they rely on to survive?

[Fenella123]

Pension funds have borrowed money and used Government bonds (aka gilts, basically chunks of debt) as security.
But, the bonds date from when interest rates were low. Interest rates and inflation are higher now, so buyers will pay less, now, for a bond that only pays (say) 1% interest.

The companies that lent the pension funds money have a bit in their agreement that says, "if the bonds you're using for security drop in value below such and such a price, you have to pay us money to make up for the fact that the 'security' is worth a lot less". Maybe the loan even gets called in in its entirety.

So where are the pension funds going to get that extra money from?

By selling some of the bonds they own...and so the prices of those bonds drop a bit more (the bond buyers know they NEED to sell, so will pay as little as they can).
So the remaining bonds they own drop a bit more in value and ooooohhhh look a nasty downward spiral right!there!

Bank of England goes, "whoa Nellie let's not see the Teachers' Pension Fund" (or whatevs) go bust" and starts buying bonds, which means the prices of those bonds go up, which puts a brake on that downward spiral.

[Wherearemymarbles]

Yep as pp said. Bond a fixed interest for a fixed term investment
As a simplified example say you have a £1 million bond for 10 years at 1%That gives you £10,000 a year interest. If new bonds are paying 10% interest, ie £100,000 a year no one wants to pay £1 mill to earn £10,000, they want a 10% return so your bond that cost you £1 mill is now worth £100,000 as it then yields 10% (£10,000 per year)

basically after the budget risk went up so the interest rate on guilts went up reducing the value of the older lower interest rate guilts.

[Idratherbepaddleboarding]

I still don’t understand even with the lay mans explanations 🙈.

[Catonamountain]

@Idratherbepaddleboarding

I still don’t understand even with the lay mans explanations 🙈.

Nor do I, I keep reading and reading it but it's just like blah blah blah, I wish I understood

[Getoff]

Vinniepolis explanation is my understanding of the original issue, I'm not aware of any news about Friday though.

Although Kwarteng may have elbowed these pension funds in the ribs, if they fall off a cliff, it will mainly be the pension fund manager's fault, for standing at the edge of the cliff for the past several years. Murphy's law says that what can go wrong will go wrong, so if you stand at the edge of a cliff for long enough, eventually something will happen to put you in the rocks.

[lannistunut]

@1jan2020

What I would love to know is - will all this affect interest rates and therefore mortgage rates?

Yes

[Thriwit]

@Wherearemymarbles

Yep as pp said. Bond a fixed interest for a fixed term investment
As a simplified example say you have a £1 million bond for 10 years at 1%That gives you £10,000 a year interest. If new bonds are paying 10% interest, ie £100,000 a year no one wants to pay £1 mill to earn £10,000, they want a 10% return so your bond that cost you £1 mill is now worth £100,000 as it then yields 10% (£10,000 per year)

basically after the budget risk went up so the interest rate on guilts went up reducing the value of the older lower interest rate guilts.

Thank you for this explanation! This is the one that’s finally allowed me to get my head around the entirety of the situation!

[1jan2020]

@lannistunut

Yes

Thanks for replying in language I can understand at least! Is it therefore best I fix my new mortgage rate now?

[1jan2020]

Or should I wait longer to see if the market calms down?

[miceonabranch]

Will pensions that are currently paying out continue to do so?

[AloysiusBear]

1jan2020

Let me just consult my crystal ball...

No one really knows. If we did we could make a killing.

Choose whether to fix based whether you need longer term certainty, not based on trying to call what will happen on rates.

[AloysiusBear]

Miceonabranch

Depends if you mean DB. Yes, some poorly managed smaller schemes could fail, there are protection systems in place though.

[MarshaBradyo]

@Vinniepolis

My understanding is: a lot of defined benefit pension funds use an investment called LDI where they buy gilts, then sometimes they use those gilts to borrow money to buy more gilts - sometimes a few times over. When the value of gilts fall, the pension funds have to stump up more money as collateral for those loans - so they sell off gilts, which drives down the price of gilts further etc, so they could end up in a death spiral and have to sell everything ie go bust. Frany the investment advisers should all be sacked or sued - they have promoted gilts as a failsafe low-risk investment to pension fund trustees, but failing to mention that this all works as long as interest rates stay unrealiistically low… Not all pension funds are affected - the ones that haven’t used LDI irresponsibly are actually in a better position overall.

This reminds me of The Big Short where Selena Gomez is in a scene to explain CDOs

[FiveMins]

My understanding is that the Conservatives fucked up my chance to easily retire abroad as I was planning to in Greece thanks to Brexit. And now have put mine and DHs very hard earned pensions at risk. Meaning that we will be struggling in old age as we did most of our lives.
All so that their hedge fund friends and the ultra rich make even more money.
This is not thinking about the hell that will play out for vulnerable people.

[Whatiswrongwithmyknee]

@Vinniepolis

My understanding is: a lot of defined benefit pension funds use an investment called LDI where they buy gilts, then sometimes they use those gilts to borrow money to buy more gilts - sometimes a few times over. When the value of gilts fall, the pension funds have to stump up more money as collateral for those loans - so they sell off gilts, which drives down the price of gilts further etc, so they could end up in a death spiral and have to sell everything ie go bust. Frany the investment advisers should all be sacked or sued - they have promoted gilts as a failsafe low-risk investment to pension fund trustees, but failing to mention that this all works as long as interest rates stay unrealiistically low… Not all pension funds are affected - the ones that haven’t used LDI irresponsibly are actually in a better position overall.

This is the one I understand the most but I'm still not getting it.

What does 'use those gilts to borrow money to buy more gilts' mean? Why would a gilt help you borrow money?

'When the value of gilts fall, the pension funds have to stump up more money as collateral for those loans'. I'm not getting this either. What sort of loan requires you to stump up more collateral some time after you've taken them out? Were the terms of the loan not clear at the start?


I know the confusion is all mine. This is so over my head.

[Bookclub99]

This is what is happening:

A Gilt is debt issued by the UK. When the Treasury needs to borrow money, it issues a Gilt (effectively an IOU note) to investors. For example, if the Treasury issued a £100 4% coupon 5-year Gilt, it would receive £100 from an investor and give them in exchange an IOU note in which it promised to repay the investor £100 in 5 years time and in the meantime pay them £4 of interest each year. The investor doesn't have to hold the IOU note until the Treasury repays the debt at the end of 5 years. It can sell the IOU note to other investors or buy more IOU notes from yet more investors if it wants to.

For reasons I won't go into here (because it will take ages to explain) defined benefit (aka final salary) pension schemes need to invest the money they will ultimately use to fund their members' pension payments in Gilts. Lots and lots of Gilts. So many, in fact, that they borrowed money to buy those Gilts. For example, if a pension scheme had £100, it went and borrowed an extra £200 and invested £300 in Gilts. Borrowing money to invest in something magnifies gains and losses. In the example given above, if you had invested just the original £100 and your Gilt investment lost 20% of its value you would have lost £20, leaving you with £80. However, if you borrowed £200 and invested £300, then you would have lost £60, leaving you with just £40 once you had paid back the £200 you borrowed.

For yet more reasons I won't go into (because I lack the skill to explain this in layman's terms), when interest rates rise, the price of Gilts falls.

The Bank of England sets interest rates and uses them to control inflation by increasing them when inflation threatens. Because of a mix of Brexit, Covid shutdowns in China and Russia's invasion of Ukraine, there have been supply shortages of certain things (e.g., oil/gas because of the Ukraine thing). This has led to inflation because when things are in short supply their prices increase.The Bank of England has raised interest rates to combat this inflation. This led to the price of Gilts falling. A lot.

Then old Truss/Kwarteng come along and announced a load of tax cuts. Tax cuts are inflationary because people have more money to spend, further driving up the price of those things in short supply.

This meant the Bank of England had to raise interest rates even more. The price of Gilts fell further. A lot further.

Now back to those pension schemes. They are making huge losses on their Gilt holdings. Because they borrowed money to invest in those Gilts, their losses have been magnified, and the people who lent them the money are now demanding they pay it back, so the pension schemes are having to sell Gilts to repay the money, further driving down the price of Gilts... it's a vicious cycle.

To help the pension schemes, the Bank of England offered to step in and buy Gilts. By buying Gilts, the Bank of England drives their price higher, thereby stemming the pension schemes' losses and arresting that vicious cycle. However, the Bank of England really doesn't want to do this. The reason why is because the Bank of England has to print money to buy the Gilts. Money printing is inflationary... so will ultimately drive interest rates higher (to control the inflation), which will force the price of Gilts lower, so the Bank of England has to print more money to buy more Gilts to save the pension schemes... and so on. Another doom loop. That is why the Bank of England put a time limit on buying Gilts - they wanted to do just enough to buy the pension schemes some time to stablise themselves - then stop to avoid the doom loop scenario. That time limit expires this Friday.

People thought the Bank of England might extend the time limit because the pension schemes are still in a huge mess, however the governor has just said that won't happen (presumably because he wants to avoid the doom loop scenario). So now everyone is shitting themselves.

It's all horribly messy. I don't know how this will be fixed, but the only realistic options are: 1) the Bank of England capitulates and starts buying Gilts again (this isn't a good answer because of the doom loop issue), or 2) Truss/Kwarteng reverse all their stupid tax cuts and resign.

If neither of those two things happens some pension schemes may make irrecoverable losses which would mean they wouldn't have enough money to fulfil the promises they made to their members. The only way to fix this would be for the pension scheme employer to put money into the scheme (some won't have enough), for the government to put money into failing schemes (i.e., a bailout) and/or the pension schemes break their promises to their members and don't pay them as much money as they said they would when the members retire - likely a combo of the three.

[Bookclub99]

Wow. That was a long post. Does it help?

[WatchoRulo]

The short version is -
Spivs in the City of London and their Tory mates will always rig the system to ensure they get richer and ordinary people lose out. They work tirelessly to dream up newer and more complex ways to piss out money away but keeo theirs.