The Blog

23rd September 2022 – The Day Britain Nearly Collapsed

May 13, 2024 | Corporates, Investors, TEA Insights

By Joseph Vambe

What Happened?

On 23rd September 2022, then-Prime Minister Liz Truss announced her ambitious “mini-budget” aimed at revitalising the British economy with an estimated £45 billion tax cut package. The intention was to stimulate growth through policies like slashing income tax from 20% to 19%, abolishing the 45% higher tax bracket, reversing the planned increase in corporation tax, and rolling back national insurance hikes. However, these drastic tax reductions were unfunded, creating a funding gap that spooked the financial markets. 

The mini-budget triggered immediate turmoil in the markets. Sterling plunged to historic lows against the US dollar, signalling a loss of investor confidence in the government’s fiscal strategy. Concurrently, the yields on UK government bonds, or gilts, soared as investors demanded higher returns to hold what they perceived as riskier assets. This rapid rise in gilt yields had a catastrophic effect on liability-driven investment (LDI) funds used by defined benefit pension schemes. 

LDI funds are designed to help pension schemes align their assets with future liabilities, often by leveraging gilts to hedge against inflation and interest rate changes. By using derivatives, LDIs allowed pension funds to amplify their exposure to long-term government bonds while investing in other higher-yielding assets. This strategy was intended to provide greater returns while still securing future pension payouts. 

However, the sudden spike in gilt yields after the mini-budget caused the value of gilts held by LDI funds to plummet. This triggered urgent margin calls, forcing pension funds to liquidate their most liquid assets, including gilts, to raise cash. As more funds scrambled to sell gilts, their value continued to spiral downward, creating a self-reinforcing doom loop that threatened to decimate the pension funds and destabilise the entire financial system. 

The timeline of the crisis unfolded quickly: the mini-budget was announced on 23 September, sterling immediately fell to historic lows, and the Bank of England intervened on 28 September with a £65 billion bond-buying programme to stabilise the markets. In just a matter of days, Truss’ economic plan had exposed severe vulnerabilities in the pension sector, brought on by the complex, leveraged nature of LDI funds and the lack of a buffer to withstand such rapid market shifts. 

How Did It All Unravel? 

The situation quickly spiralled out of control after the announcement of Liz Truss’ mini-budget. The markets were alarmed by the scale of the unfunded tax cuts, which required significant borrowing. This, coupled with already rising interest rates and soaring inflation, led to a swift sell-off of UK government bonds (gilts), driving their yields sharply upwards. The surging yields caused a dramatic devaluation of the gilts held by pension funds using LDI strategies, forcing a cascade of collateral calls. 

In these investment strategies, gilts were used as collateral to support leveraged positions, meaning that when their value fell due to the mini-budget shock, pension funds were required to find additional cash to cover the margin calls. However, the sudden surge in gilt yields and the ensuing liquidity crunch left many pension funds unable to meet their obligations, compelling them to sell their gilts in a hurry. This created a vicious cycle, where rapid gilt sales further depressed their prices, deepening the crisis. 

As a result of this sell-off, the Bank of England had to step in on 28 September with a £65 billion emergency bond-buying programme to stabilise the gilt market and prevent a collapse in the pensions sector. Without this intervention, the “doom loop” of collapsing gilt prices and spiralling margin calls would have continued, pushing numerous pension funds towards insolvency and risking the entire financial system’s stability. 

The connection between the LDI crisis and Liz Truss’ mini-budget is unmistakable. The announcement of drastic, unfunded tax cuts sent shockwaves through the markets, particularly as this budget was perceived as a pivot away from fiscal discipline during a period of economic instability. Truss and then-Chancellor Kwasi Kwarteng’s package was intended to foster growth, but the immediate lack of clarity over how the cuts would be funded led to a loss of investor confidence, precipitating a financial storm. 

Contextually, this budget was delivered amidst a global economy recovering from the COVID-19 pandemic, rising inflation rates, and tightening monetary policies worldwide. Markets were already jittery about the economic outlook, and the mini-budget’s apparent disregard for fiscal stability and lack of coordination with the Bank of England proved a devastating miscalculation, setting off a chain of events that ultimately forced Truss to resign after just 50 days in office. The subsequent market panic highlighted systemic vulnerabilities within the pension sector and revealed the potentially catastrophic consequences of LDI strategies during times of market stress. 

Who Is Responsible? 

Responsibility for the pension fund crisis following Liz Truss’ mini-budget lies with multiple stakeholders across the political, regulatory, and financial sectors. 

Firstly, the government itself played a significant role. Liz Truss and her Chancellor, Kwasi Kwarteng, were the architects of the mini-budget that unleashed economic chaos. By announcing an estimated £45 billion in unfunded tax cuts, they spooked investors who viewed the fiscal policy as reckless and devoid of a coherent funding strategy. The rapid and substantial rise in borrowing requirements undermined confidence in the government’s economic stewardship. Moreover, the decision to sideline the Office for Budget Responsibility (OBR) from offering a forecast at such a pivotal moment further aggravated market concerns, amplifying the volatility. 

The regulatory bodies also bear some responsibility. The Pensions Regulator (TPR), which oversees the defined benefit pension schemes using LDI strategies, failed to adequately monitor the risks involved. The Bank of England had highlighted the potential dangers of these strategies in 2018, yet TPR did not gather enough data or impose strict enough guidelines to ensure schemes could withstand rapid market movements. The Bank of England itself was criticised for not fully anticipating how these systemic risks would manifest in such a sudden shock, although it did step in to contain the damage with its £65 billion gilt-buying programme. 

Investment consultants and LDI fund managers played a role too. Their promotion of complex, leveraged LDI strategies allowed pension schemes to take on substantial risks that were not fully understood. They presented LDIs as a low-risk method to hedge against interest rate and inflation changes without sufficiently communicating the vulnerability to sudden market shifts. Many pension trustees trusted these advisers without fully grasping the financial intricacies of leveraged positions and the potential domino effect of a sharp rise in gilt yields. 

The entire incident reflects a broader structural issue within the UK political and economic system. It demonstrates a fragile ecosystem where government policy can inadvertently destabilise the financial sector and expose hidden vulnerabilities. The regulatory framework was also found wanting, with oversight and data collection proving insufficient to anticipate or contain a systemic risk. 

Ultimately, the mini-budget fiasco laid bare significant shortcomings across the political, regulatory, and financial realms. Each of these key players, either through direct actions or a lack of foresight, contributed to the turmoil that ensued, revealing the need for greater coordination and communication between government, regulators, and financial stakeholders. 

How Did It Play Out in the Following Days and Weeks? 

In the days following Liz Truss’ mini-budget, the LDI strategies used by pension funds came under intense pressure. The sharp rise in gilt yields triggered a wave of margin calls that LDI fund managers could not meet quickly enough. This rapid escalation led to the forced selling of gilts by pension schemes to generate liquidity, which caused gilt prices to plummet further, pushing yields even higher. As this self-perpetuating loop took hold, it became clear that the UK financial system was on the brink of disaster. 

Behind the scenes, pension funds scrambled to shore up cash buffers to meet their collateral obligations. Many were forced to offload other liquid assets, like equities and corporate bonds, to raise the required capital. However, the frantic selling of these assets created additional market instability and exposed pension schemes to significant losses. With assets being liquidated at distressed prices and yields rising to levels not seen since the late 1990s, the schemes faced a dire situation where their funding status was rapidly deteriorating. 

The Bank of England intervened on 28 September with a £65 billion emergency bond-buying programme to stabilise the markets and prevent the widespread collapse of pension schemes. This move provided immediate relief, temporarily halting the sell-off in the gilt market and bringing yields back down. However, the damage was already done. Investors were left jittery, and confidence in the UK government’s economic management had plummeted. 

The fallout extended beyond the pension sector. Mortgages quickly became more expensive as banks adjusted their rates to reflect the higher costs of borrowing in the gilt market. Homeowners with variable-rate mortgages faced immediate increases in their monthly payments, while those seeking new fixed-rate deals found themselves locked out by sharply higher rates. This led to widespread financial anxiety among homeowners, with many unable to refinance due to the spiralling costs. 

Behind closed doors, Truss and her team attempted to salvage the situation, but the political backlash was overwhelming. Amid internal dissent and a loss of market credibility, she eventually sacked her Chancellor Kwasi Kwarteng in a desperate bid to regain stability. However, this only delayed the inevitable, and she was forced to resign on 20 October, just 50 days after taking office. Rishi Sunak, her successor, swiftly reversed the mini-budget’s tax cuts and implemented a more conservative fiscal strategy to restore order. 

The Bank of England continued to support the financial markets through its bond-buying programme and worked closely with regulators to identify the vulnerabilities in LDI strategies. The Pensions Regulator issued new guidance requiring pension funds to hold larger cash buffers and improve their liquidity management to meet future collateral calls. This ensured that schemes could withstand significant shifts in gilt yields without triggering a crisis. 

Parliamentary committees investigated the regulatory failings and recommended that the government improve its oversight of the pension sector to mitigate systemic risks. They also called for tighter rules around LDI leverage, better communication between regulators and policymakers, and clearer stress-testing guidelines for pension funds. The Bank of England conducted a comprehensive review of the gilt market and identified ways to enhance resilience in the financial system. 

Today, nearly two years later, the effects of the mini-budget are still felt. Market confidence has recovered slowly, but higher mortgage rates remain, and households continue to struggle with the increased cost of living. Many pension funds have had to adjust their investment strategies, reducing their exposure to LDI leverage and diversifying their portfolios to mitigate future risks. 

The episode highlighted critical flaws in how the UK manages systemic financial risks and reinforced the importance of clear fiscal communication and coordination between government and regulatory bodies. While immediate measures have been taken to stabilise the financial system, the long-term challenge remains to rebuild trust in the UK’s economic policy framework and ensure that such a near-catastrophe never happens again. 

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