There’s Never Just One Cockroach: The United Kingdom’s Pension Funds, FTX, and Japanese Central Bank Sleight of Hand
In August of 2007, then Federal Reserve Chairman Ben Bernanke told Congress that the subprime crisis would be contained. We went on to have the Great Financial Crisis GFC), of which the subprime crisis was just one cockroach.
Now we’re facing another financial crisis- potentially worse than the GFC- caused by another 15 years or so of kicking the can down the road through reckless money creation and irresponsibly fiscal policy. Interest rates that were too low for too long caused destructive misallocation of capital. Too much debt limits an economy’s ability to grow.
History tells us it always ends badly when the government’s financial model becomes unsustainable. Modern Monetary Theory didn’t (and couldn’t) work. We got the inflation we deserved.
A long-term debt crisis- the kind we are facing now- doesn’t just show up at a moment in time. It happens as cracks in an increasingly dysfunctional and fragile system evolve. That’s started to happen, and I want to tell you about three of those cracks.
Not too long ago, Liz Truss was elected Prime Minister of the UK. She resigned after only 45 days. Some of you may have seen the web page where there was a picture of her next to a head of cabbage. The goal was to see which would last longer. The cabbage won.
Upon becoming prime minister, Liz immediately announced 45 billion pounds of tax cuts (mostly focused on the wealthy) with no explanation of how they would be paid for- apparently with more debt.
The reaction of the bond market was not exactly positive. Government bonds (“gilts” as they are called in England) cratered something north of 25%. Interest rates jumped to 5%.
Meanwhile, UK pension funds had been struggling to earn enough money to pay their pension obligations while interest rates were down around zero. But never fear! As always, the investment bankers were there to help. For a healthy fee. They got the pension funds (not just in the UK I bet) to invest in something called a liability driven investment (LDI) which used derivatives and worked just great in generating income as long as interest rates were declining.
Rates rocketed up due to the bond market’s skepticism of her plans. The value of the pension funds’ collateral (the gilts) declined, and they had to sell their gilts to put up more collateral. The more they sold, the further prices fell and the more they needed to sell. I think I read that the margin call totaled something like 1.2 trillion pounds. They didn’t have that lying around or they wouldn’t have needed the LDI in the first place.
On September 28th the Bank of England (BOE) had to step in and start buying government bonds again. It hadn’t been long since they’d started selling what they had. Later, they also announced a short-term lending facility to provide more liquidity.
This all worked for a little while, but then interest rates started rising again. A head had to role, so Liz fired her Chancellor of the Exchequer somehow ignoring that these were her policies. Obviously, it didn’t work and not to long after, Liz lost to the head of cabbage.
The new Prime Minister has largely reversed the tax cuts. In fact, he’s proposed some new taxes and cuts in government spending. This is generally known as austerity. With energy prices already where they are, the UK is looking at a further decline in its standard of living. But hopefully, the bond market can be kept happy.
Not even sovereign first world states can issue debt forever without it catching up with them.
Closer to home- in the Bahamas to be more specific- Sam Bankman-Fried (SBF to all his friends, if he still has any) founded FTX in 2019.
“Its 28year-old founder and majority shareholder, self-styled as “SBF” (Sam Bankman-Fried), was a graduate of MIT and low-level ETF trader at Jane Street. He then established a two-year track record trading crypto assets through his personal hedge fund, Alameda Research, and launched FTX as an ultra-liquid trading platform for professional traders. FTX did not have a board of directors. Its auditor has an office in the “Metaverse.” Yet FTX managed to attract investments from some of the largest players in Wall Street and swiftly became the second-largest crypto exchange.”
I’m quoting from a paper by Daniel Oliver at Myrmikan Capital LLC. It’s called Crypto Contagion and you can read it here. It’s unbelievable and entertaining.
But if you don’t read it (your mistake) what you should know is that FTX at its heart was a Ponzi scheme. The paper describes exactly how and why by quoting SBF’s description of what he did. Meanwhile, he got institutions like Sequoia Capital, the Ontario Teachers Pension Plan, Soft Bank, and Tiger Global to invest. They are all now sorry.
At a time of endless liquidity, the lowest interest rates in 5,000 years, a long period when the market just went up, and competition to find good investments when some traditional ones are paying nothing maybe people just get too confident. Like with Lis Truss in the UK, SBF was done in by too much leverage/debt, not to mention overvaluation of some questionable crypto assets. Leverage can be a good thing- until it isn’t.
Japan, as you may know, is determined to keep their interest rates from climbing. To accomplish this, they have been buying most Japanese government issued bonds and control something over half the bond market. Effectively, their central bank is the bond market.
Recently, a strange thing happened in that market. It was reported in an occasional email I receive from David Kotok, Chairman & Chief Investment Officer of Cumberland Advisors. Acknowledging that he’s just seen an article on a report in a newsletter and not the details of the actual trade, he says:
“Here’s the trade. The central bank of Japan reached a holding limit of 100% of an outstanding issue of Japanese government debt. So, it then loaned the security to another institution that wanted to borrow it so they could sell it short. They sold short, and the BOJ bought it, which meant that the holdings of the BOJ exceeded 100% of the outstanding amount of the issue in question.”
He prefaces that comment by noting, “That act is absolutely bizarre in central bank history. We cannot find a prior example in the history of central bank over the last century.”
As I read this, the Bank of Japan bought more bonds than actually exist in the issue they bought. In their efforts to keep interest rates low, they were selling these bonds to the people who were betting against them being able to keep rates down and then buying them back. It’s so weird it must be true. It’s also, as are the other two cracks, proof that this cannot continue.
I don’t know where the next crack will occur, when it will happen, or how big it will be. Does the whole edifice come tumbling down, I wonder? You may remember this quote from Hemingway’s book The Sun Also Rises.
How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” “What brought it on?” “Friends,” said Mike. “I had a lot of friends. False friends. Then I had creditors, too. Probably had more creditors than anybody in England.”
This isn’t just a debt crisis for the United States. Lots of other countries have managed their finances the same stupid way (giving money they didn’t have to people for things that didn’t increase productivity). Did covid and the war in Ukraine speed this up? No doubt. But without those events we’d still have the same problem. But like our friend Mike above, we’d be able to go slowly for a while longer.
How do you fix a debt crisis? Well, what do you do when you have too much debt? You tighten your belt so more money can be directed towards paying the debt. Or you find a way to reduce your debt, either through negotiations or bankruptcy.
Governments have another choice. They can print money. When that money printing isn’t supported by productive activities, it causes inflation. But inflation reduces the value of debt because you are repaying that debt with dollars that are worse less.
If you were an elected official, what would you do? Tell your constituents you were going to cut all their benefits? Not the best way to get reelected, though I’d vote for anybody who was that honest. Nah, you’d hope or even engineer or allow inflation to reduce debt as a percentage of GDP. Kind of stealth benefit cutting.
If that wasn’t part of the (off the record) conversation in the Federal Reserve building as they kept calling inflation transitory, I’d be stunned.
What’s the point of this article, aside from making me feel better by writing it all down? I am guessing that many of you haven’t seen much about the inevitable result of a the end of a long-term debt crisis in print. And you don’t really know just how bad our financial situation as a country is. Those of you who want to dig a little deeper can let me know, and I’ll be glad to share some credible sources with you.
The United States will ultimately be fine (that’s another article), but we’re in for some rough years. It would be a lot easier if we realized we’re all in the same boat. Hopefully, that boat’s name doesn’t start with a “T.”