Europe’s biggest asset manager has warned that the tremors in the UK pensions market should be a “wake-up call” to investors and regulators about the dangers of hidden leverage in the financial system.
Vincent Mortier, chief investment officer at Amundi, which holds €1.9bn in assets, said in an interview that the recent turmoil unleashed by the UK government’s ‘mini’ budget was “a reminder that shadow banking is a reality. I don’t think anyone before the crisis had any idea of the extent of this shadow banking in the pension fund industry”.
Former Chancellor Kwasi Kwarteng shocked the markets with £45billion in unfunded tax cuts on September 23, pushing up UK government bond yields and wreaking havoc on Britain’s defined benefit pension sector. £1.4 billion from the country, which uses specialist hedging strategies to help schemes better match their assets and liabilities.
The strategies, known as liability-driven investing, have built-in leverage because they use a variety of derivatives that allow pension plans to increase their exposure to gilts, without necessarily owning the bonds.
Falling gilt prices led to a rush of margin calls as counterparties demanded more cash as collateral to keep the hedging arrangement in place. Funds were forced to sell assets, including gilts, to meet the calls, driving prices further down in a vicious circle that eventually led to intervention by the Bank of England.
Reliable data on leverage in the UK pension fund market is hard to come by, but experts estimate that LDI leverage has turned £500bn of underlying assets into 1 .5 billion pounds of money invested.
“The amounts at stake were huge and it’s a further reminder of the depth of leverage in the system, which is in several hard-to-follow places,” Mortier said.
The increase in capital requirements imposed on banks to make them safer in the wake of the financial crisis has shifted risk from their balance sheets to less regulated parts of the financial system, namely asset managers, insurance and pension funds. Investors fueled change by pouring money into alternative strategies such as private credit as they searched for yield in a low interest rate environment.
In 2000, non-banks held $51 billion in financial assets, compared to $58 billion for banks, according to the Financial Stability Board. Its latest data showed that non-banks held $227 billion in financial assets at the end of 2020, surpassing banks at $180 billion.
Mortier said shifting leverage from banks to non-banks made it very difficult for regulators to get a true picture of risk.
“It’s a lot harder than in 2007, when leverage was mostly in the banks,” he said. “The problem is that we don’t know exactly where he is. When you can’t measure something, it’s hard to act on it.
Mortier identified several areas where hidden leverage could be a problem: OTC derivatives, which are traded privately, away from exchanges; real estate and parts of the private credit market, including leveraged loans.
The BoE’s Financial Policy Committee recently warned of risks in US private credit markets. He noted that leveraged loans had risen from about $2 billion in 2017 to $3 billion at the end of last year, and said companies with such debt “were susceptible to be particularly vulnerable to tighter financial conditions and weaker growth prospects.
Mortier also pointed to the collapse of family office Archegos Capital Management as an example of how leverage can build up under the radar. Archegos founder Bill Hwang borrowed billions of dollars from blue-chip banks to acquire huge positions in US-listed companies. By using derivatives, where the bank it was dealing with bought or sold shares on behalf of Archegos, the company left no visible footprint of its activity to the investing public.
Archegos’ collapse caused billions of dollars in losses for investment banks including Credit Suisse, UBS, Nomura and Morgan Stanley after it defaulted on margin calls, with more than $100 billion wiped out of valuations of nearly a dozen companies while Archegos’ positions were unwound.