Thread by @CaitlinLong_

1/ THINKING ABOUT all things bond mkt after catching up on morning reading☕️. 15yrs of my #WallSt career was helping pension plans/life insurers fix their past mistakes (most of which made them inherently short vol). Fundamental probs w/ bond mkt structure exacerbated this prob.

2/ The underlying issue pertains to how fin mkts deal with duration. Pensions & life insurers have the longest-duration liabilities in the fin system & yet they scramble to find duration-matched assets to buy bc there’s either a structural shortage of them, or they’re in banks.

3/ In the UK, where mortgages are mostly floating-rate, UK govt issuing long-duration gilts is the primary source of long-duration assets for pension funds. High % of UK pension liabs are inflation-indexed too (far more than in US) & again the offsetting asset comes from UK govt.

3/ The UK long ago decided to be responsible about solvency of its pension plans & require them to be ~fully funded. But they faced a structural prob: not enuf duration in the bond mkt was available to buy (same thing for inflation protection). So they hedged with derivatives.😳

4/ That transferred the structural insolvency prob from the pensions to the UK bond mkt, causing the prob to manifest as the collateral shortage we’re now seeing (& which is trapping the UK govt). There was an implicit generational wealth transfer in all this bc the fundamental…

5/ …insolvency of the pension plans (exacerbated by the high % that are inflation-indexed) was implicitly transferred from older generations to the whole population. I dunno how the UK situation will turn out, but in all the analysis of it I haven’t seen much discussion of…

6/ …loosening the rqmt that pension funds be ~fully funded, thus putting the true insolvency prob back where it originated in the first place (& relieving the stresses it is transferring to the broader UK financial system). I’m not advocating for that—just observing & thinking.

7/ The very prob that has manifested in the UK bond mkt (as a collateral shortage) was an obvious risk to those working in this area. We called it “gap risk”—the risk of a gap up in interest rates triggering a massive collateral call. Amazing it didn’t happen sooner than it did.

8/ Of course, the real cause of pension fund stress has been obvious for yrs: demographics. Bond mkts can’t fix that.

Now to US. Same demographic prob but bond mkt structure is v diff for 2 basic reasons:
* bond mkt has more duration avail
* pension liab structure v different.

9/ Re: duration, a high % of US mortgages are fixed-rate not floating-rate so there’s more duration available for pensions to buy. But US has a mkt structure prob —due to bad regulations, the duration is mostly sitting on bank balance sheets & in bond mkt, not in pension funds(!)

10/ Myriad bad regulations cause this, but big picture is this: pensions/life insurers are the natural source of demand for long-duration assets, while banks are not. Yet, banks (funded by short-term deposits) originate most of the long-duration assets, exposing banks to run risk

11/ Were we to create a new financial system from scratch, we wouldn’t have banks engage in maturity transformation while forcing pensions/insurers to scramble to buy that duration from banks via the bond mkt. Instead, the originators of long-duration liabilities would be…

12/ …the originators of long-duration assets. Such a system would be fundamentally more stable than the one we have today, where there’s way too much leverage in the derivatives used to close these structural duration gaps (which periodically manifest as collateral shortages).

13/ Such a system wld also take pressure off central banks to act as lender of last resort when structural duration gaps rear their ugly heads periodically. I know what some of u are thinking—there’s not enuf duration in mortgages to solve the pensions’ duration mismatch problem.

14/ True. But think about the embedded options in most fixed income instruments—eg, mortgage prepayment options. Why do banks/bond mkt love those? bc the originators of most of those instruments don’t have long-duration liabilities, so they create ways to shorten their duration.

15/ Were the originators of such long-duration assets actually funded by long-duration liabilities, the incentive to shorten duration synthetically by creating embedded options would be far lower.

Finally, let’s compare US vs UK pension liability structure. Huge differences.

16/ * US long ago largely shifted away from defined-benefit to defined-contribution pensions, thus transferring the pension solvency prob to individuals (except for public sector pensions)
* US was less responsible than UK—US doesn’t actually require pensions to be fully funded…

17/ …(bc US pension accounting rules play games w/ interest rate assumptions to paper over some of the problem) &
* almost no US corporate DB pension liabilities are inflation-indexed. (All else equal, an inflation-indexed pension liab is worth ~40% more than a non-indexed one.)

18/ (Most public sector pension liabs in US are inflation-indexed, but most public sector plans aren’t required to be even close to fully-funded.)

In sum, there are structural pension insolvency probs in both US & UK, but they won’t manifest the same way. UK is seeing it first.

19/ Finally, yes working in pensions helped me see the value of #Bitcoin. Satoshi gave us a gift—one that can help create a fundamentally more stable & fairer financial system, free from the implicit wealth transfers of the current one. But that’s only if we don’t screw it up…

20/ …by building the same mkt structure problems of incumbent systems into its markets. No, #Bitcoin can’t solve a demographic problem (duh😜), but a true yield curve can help clarify the true costs of insolvency so society can make better decisions about how to resolve them/.