I’d like to make kind of a meta-point about what I see as two different ways that people are talking about the issue in this rather contentious thread.
To oversimplify a bit, there seems to be a crowd saying: “these pension fund managers gambled with my retirement to enrich themselves”.
There seems to be another crowd saying: “if you examine the details of these transactions you’ll find that it’s neither that simple nor fundamentally even true”.
I’d like to submit that the latter group, which I suspect is probably technically correct (the best kind) should possibly examine the possibility that while any isolated derivatives transaction probably makes sense and is governed by deep and sophisticated mathematics, it does seem to be the case that in sum total we see, decade after decade, a cumulatively destabilizing effect on both financial markets and the financial security of everyday folks: somehow the emergent system either is or really, really fucking appears to be privatizing profits while socializing losses while simultaneously driving up the swings of the business cycle.
I love the financial mathematics stuff intellectually and this is certainty a forum that welcomes experts discussing details, but at some point we need to acknowledge that it’s high finance’s job to convince the public that they’re actually helping, not the public’s job to learn high finance.
Elites that forget this for too long have historically come to very bad ends.
The destabilizing threat is real and systemic. Derivatives allow us to hedge local risks at the cost of creating the possibility of the whole system collapsing. It greatly concentrates risk in those who wish to gamble, and if their gambles go south allows them through leverage to threaten the whole financial world.
This is not just a contrarian view. Go to https://www.berkshirehathaway.com/2002ar/2002ar.pdf and start around page 13 where it says "Derivatives" for Warren Buffett's analysis. This is the one where he calls derivatives "weapons of financial mass destruction". (This was several years before the 2008 financial crisis.
He makes a number of good points. One of which is that we value derivatives is based on complex models. Those models inevitably have errors. And the errors are generally in favor of the side that you purchased. So those engaging in the trades always believe that they are making money (and bonuses etc get paid on this basis), no matter how disastrous it may later turn out to be.
In this case it is likely that the pension fund managers never realized what kinds of complex gambles they were making or what the real risks are. They were working according to models in which what they did was wise. And it may well be that they were right in the long run. But as Long-Term Capital famously showed, being right in the long run only matters if you survive to see it. It remains to be seen if these pension funds will survive.
But in this case, there was no error on derivatives. It was unforeseen and very violent market move in the response of Tory’s policy “more tax cuts” and the general loss in the faith that the UK economy will be productive and surplus any time soon.
Those who modelled the risk did not think Tories would do anything that stupid and risk the UK economy.
The fact that the model did not account for what actually happened as possible IS a problem in the risk model.
Pension funds are supposed to run for decades. Looking at the last 12 decades, I see many financial crises, a run on the pound, the Great Depression, a couple of world wars and so on. All of which were unthinkable until they happened. Any risk model meant to cover long periods should account for the possibility of similarly extreme events happening in the future, at roughly the historical frequency.
But you're telling me that those who modeled the risk failed to give this ANY consideration at all?? And then you say that you think that this oversight is not an error??
I would take even a somewhat kinder view of the pension funds involved. With no knowledge of the intimate aspects of the agreements UK pension funds make with employers, those involved knew that you could either pay for the risk margins involved up front, or via emergency capital.
Margin calls are nothing special. Derivatives are used for balancing assets and liabilities, since you cannot match the cash flows on pensions directly given the very long duration (cash flows for pension funds run for nearly a century). Swaptions etc are nothing evil. They are pretty clear cut tools for the job of limiting interest rate exposure for parties with very long liabilities.
This is not a pension fund problem (I agree up front: that's a reductio nearly ad absurdum), it's an employer and pensioner problem, created by a sudden loss in confidence in UK gov in an already very turbulent market. If sterling falls, purchasing power falls, interest rises, there is no way pensions can keep purchasing power or indexation. Margin calls are a tiny symbol that shouldn't worry a risk manager. It's the larger enviroment for the UK - that is very worrying.
It's all hocus pocus but a well run insurer or pension fund should have a pretty solid grasps on interest rates and a pretty low exposure to swings in that rate. Same for FX exposure. End of '21 you should have opened up some upward potential in interest rates and have some room to survive that volatility. The best managed ones keep afloat or even profit, without taking too many excess risks. The worst managed ones are the first to fall. Go and look at the Q3 financial results for the largest _worldwide_ insurers. I predict the largest insurers will show stronger financial capital positions. (Stocks will fall since large insurers are partially valued on general stock market performance since they are in essence also investment companies.)
Again, margin calls are a symptom caused by the underlying agreements, with not a direct relationship to which ones will fail or prosper.
It reminds me of a what a friend of mine said who priced Mortgage Backed Securities before the financial crisis "Oh, we never modeled different mortgage default rates - those were fixed assumptions. The really complicated math was driven by interest rates."
He did leave me with the impression that tnterest rate modeling was technically challenging and had lots of scope for sophisticated work - so that's where the effort went.
1. Just because papers always seem to know why markets move, doesn't make it true.
2. Margin calls happen when you are short, highly leveraged or not hedging properly (derivatives going wrong). Should "pension funds" do any of these things ?
Is the "tax cut" justification the real cause though? The Euro and Yen plunged in lockstep with GBP, which suggests a more fundamental issue beyond just the UK market. I have to wonder if the mini-budget was just used as justification.
There’s no complex modeling required here on an interest rate swap. The payout on swaps is easily calculable and the range of outcomes knowable. There’s not much overlap in the context of what Buffett talked about and what happened here besides the word “derivatives” and the idea of exogenous shocks tending to lead to outcomes outside your range of modeled assumptions.
I’d be glad to engage more but it seems like you are fixated on a slant and cannot be convinced otherwise.
I think the equivalent would be if, a very modestly able coder, were to insist on this forum that nobody should ever have loops in their code because sometimes they do weird things.
> The payout on swaps is easily calculable and the range of outcomes knowable.
While this is technically correct, it's the solvency of the counterparties that is not easily calculable or knowable. Derivatives must be viewed in the totality of the system in which they are used. Focusing on the fact that payouts are calculable and therefore perfectly safe in isolation is extremely myopic.
> I think the equivalent would be if, a very modestly able coder, were to insist on this forum that nobody should ever have loops in their code because sometimes they do weird things.
I think the equivalent would be if, a very modestly able coder, were to insist on this forum that because the database is up 99.9% of the time, there's nothing wrong with not handling errors, because the DBA team is running with an average IQ of 143, they all went to MIT, they know what they're doing, black swans do not exist, and that 99.9% might as well be 100.
Derivatives are inherently dangerous because they are a knowable mathematical system coupled quite tightly to an unknowable system of risks. You can't mentally decouple them and claim that welp, the math works, it's fine, ship it.
And given the web of interdependencies among the counterparties, every counterparty should be assumed to be overly exposed to a systemic risk that everybody is currently discounting. If that risk happens, it will be difficult to predict who will be affected, and it will be impossible to unwind the deals in a hurry.
We have had a number of financial crises that have required external intervention to keep the whole system from melting down. Most famously, 2008. And they show how quickly a solid counterparty that everyone trusts becomes a source of contagion that poses a risk to everyone touching them.
If we have a long planning horizon, what kinds of shocks should we be prepared for? Well here are a few sample scenarios.
1. Russia collapses, leading to nukes floating around to bad hands.
2. China finally invades Taiwan, threatening everything that needs computer chips.
3. A US government shutdown finally results in non-payment of Treasuries, causing a "risk-free" investment to have to be priced for risk.
4. A repeat of the 1859 Carrington Event happens, with damages in the trillions of dollars. No seriously, https://www.space.com/the-carrington-event shows how plausible this is.
The financial system treats all of these as unthinkable and therefore impossible. But between all of them, over a period of decades, the risk of SOMETHING on this order of magnitude happening is significant. It is a problem that the entire financial system fails to appreciate that there IS a risk, let alone fails to do anything to mitigate it. Indeed, quite the opposite, the 2008 bailout has let the financial system believe that the government will always bail them out. And so has become complacent about their role in creating various minor financial crises.
But there is no guarantee that the government will always be in a position to do that. The result has been a normalization of deviance that has to end badly at some point. See https://www.ostusa.com/blog/normalization-of-deviance-defini... if you're not familiar with the phrase "normalization of deviance".
Thank you. Although I think the risk of #4 is greatly overblown. We watch the sun constantly now, and detection of an X20+ class flare aimed at us gives us about 10 hours or so to disconnect as much as we can, limiting damage to maybe only a trillion or so.
My personal favorite pet risk is a combination of #1 and #4, though. A few HAEMPs de-orbited and detonated over North America by a collapsing or collapsed Russia gives us no time to disconnect anything. And the fantasy that neither defense.gov, nor mil.ru, have many of these in orbit right now because "OMG it would be a Space Weapons Treaty violation and nobody would ever do that", is as naive as the pre-Snowden "OMG the NSA would never spy on Americans because it's illegal" normie zeitgeist.
> the equivalent would be if, a very modestly able coder, were to insist on this forum that because the database is up 99.9% of the time, there's nothing wrong with not handling errors,
Any system that socializes losses to parties that are not embarking in the risk/profit is going to be exploited. Period. This is not just about finance. It's a leak. Anything that can leak for profit, will eventually leak.
These attacks (and I don't mean you personally) to the free market (and derivative products) are dangerous. If the "free" market fails because it's not so free after all(socialized losses), you don't fix this by having more bureaucrats/politics involvement to run the markets. This will only make matters worse.
The proliferation of politics in the markets, because of that, is also accelerating. The argument is now readily available (look at how these complex derivatives products are destabilizing the market!). This will lead to more chaos in the market, more dysfunction and more organized thefts of the market (if not from smart mathematicians than from politicians/bureaucrats) and eventually to a military rule.
We've been there a few decades ago. It's sad what's happening now.
> If the "free" market fails because it's not so free after all(socialized losses), you don't fix this by having more bureaucrats/politics involvement to run the markets. This will only make matters worse
This is deeply naive. Governments that don't take action when pension funds evaporate en masse will fall and be replaced by those which do take action. If this didn't happen, it would be a failure of democracy, not of markets.
Such a government would be illegitimate - and on-topic, that's pretty much where the UK government is at right now, it's pursuing a set of policies it has no electoral mandate for and is currently 33% behind the main opposition.
(Yes — and it feels like we have a systemic problem when the people have no way to get rid of a government this unpopular — except relying on them to do the decent thing and bow out, which this bunch, having been basically purged by Johnson of anyone with intelligence or principles, will clearly never do).
But the public -- pensioners and future pensioners -- are embarking in the risk/profit side of things. We want to fund our pension with less money than we ultimately take out, and additionally have guaranteed outflows regardless of market conditions. To put it shortly, we want profit.
The average pensioner may not understand that they were joining in a risky undertaking. Whose fault that is I could not even begin to suggest -- too many possible candidates depending on your world view. But a lack of understanding will avail you little when your counterparty is the fundamental financial reality that there is no free lunch.
As annoying as it is that the bankers made a bunch of money, the alternative, where all pension monies go into a savings account, would leave people much less happy.
And fundamentally it must be risky. You are engaging in a deal to be paid a sum of money 30 years down the road, there’s 30 years of mandatory uncertainty and risk involved with that deal. With defined contribution plans at least the worker observes that risk directly (401k goes up or down) but you can’t, no matter what you do, make it not risky.
Free markets only work for certain markets - and it works in those markets exceptionally well. HOWEVER somewhere in history we decided as a group of people that free markets worked so well for these specific markets that we will apply this ideology to all markets and that will solve the problems of appropriate capital allocation.
This is indeed a fallacy and has led to the rampant problems and the perpetuation of the simplistic & naive belief that free markets will allocate capital properly and efficiently and if the free market doesn't its a function that the market isn't free enough.
I think you are assuming the derivatives in question are wild, complex, speculative derivatives. This is almost certainly not the case. They are most likely long dated interest swaps.
Pension funds have a duration problem, they are managing long term liabilities (what they owe to pensioners) and need to ensure they have enough assets to cover the present value of those liabilities. If interest rates move, then the present value of those liabilities may change a lot because of the new discounting. So they try to reduce that risk, either by buying assets that behave in a similar way with respect to interest rates, or by entering into long dated interest rate swaps. I think the leveraged repo positions they are refering to is doing the same thing as an interest rate swap by going long a long term gilt and short a short term gilt (or the other way round), but basically they try to create an interest rate mismatch to take some duration exposure.
So this is pension funds reducing the risks, not speculating.
The systemic risk here seems to be mostly a concentration problem and feedback loop. I.e. the more interest rates move up the more pension funds need to sell gilts to hedge their duration or post collateral, the more gilt prices collapse, the more interest rates move up.
Agreed, the problem isn't at pension funds; the problem is the whole financial system's excessive systemic risk.
That systemic risk can be effectively reduced, and policymakers haven't done much to address it at all due to regulatory capture. Many financial mathematicians and popular intellectuals (Nassim Taleb, James Rickards) have pointed out the need to descale the financial system to decrease systemic risk, and prevent the financial blowups that are inevitable at the current scale.
The problem has two sides. On the one hand there's finance where some people are taking risks, creating instability that will mostly hit every day folks when things blow up.
But on the other side are those every day folks. They want their pension money to gain a profit each year so they'll have a decent pension when they retire. At the very least it should match inflation but preferably a bit extra.
Investing money (almost) without taking risk is possible but you'd have to stall all the money at the ECB or some other central bank, and until recently you'd have to pay a negative interest rate. This wouldn't make pension holders very happy.
So pension fund managers take risks. They surely take as little risk as possible and they are excellent in picking opportunities that give a comparatively high yield for their risk: but they are taking a risk, otherwise they would never come close to beating inflation.
And sometimes the risk blows up, and everybody is all upset. It's easy to blame those filthy rich fund managers but people should also look into the mirror sometimes.
[1] points out that you can have a perfectly boring, safe pension fund by investing all the money into gilts with positive interest rates which means you only need to put in £48 now to get £100 in 30 years.
>it does seem to be the case that in sum total we see, decade after decade, a cumulatively destabilizing effect on both financial markets and the financial security of everyday folks
I'm not an expert in finance by any means, but for the most part this doesn't seem true. Besides the mortgage bubble, the market has only seemed to get smarter over time. There's definitely a lot of weirdness, but
that's to be expected when interest rates are less than inflation for over a decade.
>it’s high finance’s job to convince the public that they’re actually helping, not the public’s job to learn high finance.
People go into finance to make money, not to help people. It happens that making money in finance tends to make the market more efficient, which helps people. All the low-hanging fruit has been picked, so very little benefit is going to trickle down to the common folk these days, but as a whole, I don't think they're harming people.
Meanwhile, I do think that it's the public's job to learn finance, or rather strive to be more informed in general. When the public's priority is to scream out that we should eat the rich, politicians will happily virtue signal along with them and outsource the boring work of legislating to a corporate lobbyist.
> Besides the mortgage bubble, the market has only seemed to get smarter over time.
An incongruous comment on an article pointing out that the market has got dumber (ie turning the "should be perfectly safe in gilts" UK pensions market into "hours from 90% collapse because we gambled with shares")?
I don't think fundamentally that the problem here is derivatives. I think fundamentally that it is pensions themselves.
Think about what a pension is. A pension is a deliberate inefficiency in a labor market. It's a promise to pay someone for not working, and in some cases even, children of people who once long ago worked. It is also a central lever for people to look to profit on through managent, and a tool with which to overinflate demand for financial products.
The commitment taken on by a pension fund is an increasingly impossible one to uphold as time goes on and markets get more efficient. They have a bag of capital they have to make grow to continue to honor an open ended commitment, so they have to continue to find interesting and clever (and risky) ways to do that. Compounding on this, they're big bags of capital, so they will invariably become load bearing pieces of a nation's financial portfolio. Of course they're going to wind up intimately tied to the overall financial health of a nation.
"We take some chunk of money we would otherwise just pay you, promise to invest it wisely to indefinitely pay you later for not working, and in return we get a chunk of capital to play with and a sink to help stabilize the financial system." That's the proposition of a pension, right?
You might be tempted to say "pensions are just a part of agreed to compensation, a contractual obligation and nothing more. There's nothing special about a pension that gives it these negative properties your ascribe to it" and to that I'd ask, then why don't people just take the capital through their working years as monetary compensation? Surely they could hand that to a money manager and achieve the same result as a pension achieves? The answer is because people wouldn't be able to expect what they get out of a pension, they go with a pension because they think they're getting something more out of it, and that excess is the ultimately impossible commitment I am referring to.
The premise that a pension should beat the market without taking on risk does seem suspect. Other traders have the same idea with higher risk tolerance. Maybe gambling over multiple decades is a significant advantage but that's also difficult to see.
>> A pension is a deliberate inefficiency in a labor market. It's a promise to pay someone for not working...
That's and extreme simplification of pension and probably the worst definition You can think of. I guess if You were a marxist as opposed to some form of capitalist/liberal I would expect that You would base Your definition on class struggle.
I much more prefer to think about pension as a form of insurance against the risk of getting old. And as such the free market "implementation" is only one of possibilities (for ex. here in Poland we have state pension with a bit of free markets sprinkled on top). I personally believe that "old age insurance" is one of flag inventions of our times and do not think that there is a place for free for all solutions in civilized society (we are in this together and should work out a way to protect the weakest).
>> It is also a central lever for people to look to profit on through managent, and a tool with which to overinflate demand for financial products.
That's an implementation detail in my view - if You look at it from insurance perspective, You just need to search for a way to redistribute effects of current work between workers and retires. And using financial products (stocks and derivatives) may just be a wrong tool for the job.
> while any isolated derivatives transaction probably makes sense and is governed by deep and sophisticated mathematics, it does seem to be the case that in sum total we see, decade after decade, a cumulatively destabilizing effect
It's not true that derivative transactions are good in isolation and add up to something bad. The bad derivatives transactions add up to something bad. The good derivative transactions do no harm, and are good for everyone involved.
If you see a wheat grower hedging their variable yield, that's not going to add up to something bad. If you see derivatives on junk loans in a low interest rate environment, obviously that's different.
> 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.
Agree with your point, but as far as I understood that “gambling” done by the pension funds mainly happened because there’s no other way for them to pay what they’re due, i.e. the pensions themselves. In other words the pensions system slowly reveals itself as the Ponzi scheme it was from the very beginning.
"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."
I have leveraged positions on the stock market and never got a margin call, and probably never will. Being margin called is purely and simply unprofessional and irresponsible. There is no way around that.
The maths will never justify a margin call. LTCM has tried taking on extra risk justified by their oh so clever math models and ended up blowing up. People will keep repeating these kinds of mistakes until the end of capitalism.
To oversimplify a bit, there seems to be a crowd saying: “these pension fund managers gambled with my retirement to enrich themselves”.
There seems to be another crowd saying: “if you examine the details of these transactions you’ll find that it’s neither that simple nor fundamentally even true”.
I’d like to submit that the latter group, which I suspect is probably technically correct (the best kind) should possibly examine the possibility that while any isolated derivatives transaction probably makes sense and is governed by deep and sophisticated mathematics, it does seem to be the case that in sum total we see, decade after decade, a cumulatively destabilizing effect on both financial markets and the financial security of everyday folks: somehow the emergent system either is or really, really fucking appears to be privatizing profits while socializing losses while simultaneously driving up the swings of the business cycle.
I love the financial mathematics stuff intellectually and this is certainty a forum that welcomes experts discussing details, but at some point we need to acknowledge that it’s high finance’s job to convince the public that they’re actually helping, not the public’s job to learn high finance.
Elites that forget this for too long have historically come to very bad ends.