Back then, I was working at Merrill Lynch, the investment bank, and, with Paul, we had been fine-tuning the details of the transaction for several months.
It was an extraordinary and significant day which, in the end, almost didn’t happen. Late in the afternoon, the day before we were due to execute the transaction, Paul rang me; he was having last-minute doubts. He was concerned that, as far as we knew, no pension scheme had ever attempted to hedge all its interest rate and inflation risk using an interest rate swap combined with an inflation swap of this size and enormous duration.
Even more worrying, there was a significant chance that the scenario against which the pension scheme was about to protect itself, would not actually come to pass. The doomsday scenario of low interest rates and high inflation expectations was, very possibly, a phantom threat that would simply never materialize.
For those (valid) reasons, Paul was calling me to say he was minded not to go ahead.
Remember, in December 2003, interest rates were already close to historic lows. In his pre-budget report statement to the House of Commons, Chancellor Gordon Brown said:
“interest rates are at their lowest since 1955”
(and went on to make a whole lot of reassuring economic predictions that turned out to be hopelessly inaccurate (as we all found out)).
So, in 2003, the chance that interest rates would fall further, was universally considered to be remote in the extreme. And the likelihood of inflation rising as interest rates fell, was felt by many, to be an absurd notion that flew in the face of all modern economic theory. It was, as one FTSE 100 finance director informed me after reading an article I had written, “the stuff of fantasy”. Nice try, no cigar, I seem to recall was his parting shot.
Paul, then, was phoning to run through the arguments, for and against, one more time.
I grabbed our legendary ALM (assets and liability management) structurer, Philip Rose, and we nabbed a side room, away from the trading floor, and overlooking King Edward Street. I closed the door and, on the phone, we talked Paul through the rationale for the hedging transaction step by methodical step.
Yes, we admitted, this would be an industry first. Although a few pension plans had partially hedged their inflation linked and long dated liabilities by replicating a bond portfolio using derivatives, (and, indeed, a couple of years earlier, the Boots Pension Scheme had sold all its equitiesand bought long dated bonds), this transaction was of a different scale and ambition. We were planning to use super-long-duration derivatives to eliminate fully the pension plan’s exposure to falling interest rates and rising inflation. This was something even the Boots Pension Scheme had not been able to achieve with its groundbreaking 100% allocation to bonds, since it had been unable to buy bonds of sufficient duration.
So, this derivatives transaction was seriously radical Baumgartneresquestuff, and I could fully understand why Paul was having last-minute reservations.
But, I explained, the sheer size of the naked market risk being run by Friends Provident Pension Scheme (and, truth be told, every other defined benefit pension scheme in Christendom) was off the charts. It dwarfed all its other risks. In my view, there was an imminent prospect of lower interest rates combining with higher inflation to produce a super-low real yield that would cripple every un-hedged pension scheme.
Over the previous century, the real yield had, on average, been significantly lower than it was in 2003. It was a mistake to think it could not go lower. Besides, corporate accounting standards had recently been tightened, and would oblige pension funds to hedge this risk (falling real yields) eventually – either willingly, or kicking and screaming – but they were going to have to hedge. As they did so, the price of those hedges would rise due to limited supply and increasing demand. And as that price rose, so the real yield offered by those hedges (mainly gilts and swaps) would fall (a higher price means a lower yield).
Put another way, the real yield was all set to decline rapidly and severely. At the very least, this scenario was a real and present threat. And, I went on, if the real yield did fall, those pension plans that had not hedged, would ultimately find themselves in a world of pain, as the mark to market value of their liabilities escalated to the edge of Space. No asset would be able to keep pace.
There was a long silence. I could tell that his decision was finely balanced. He was within a hair’s breadth of calling the transaction off, which would have been an understandable decision. He was under immense pressure to make the right call. I told him the decision was his – we certainly weren’t able to make any definitive predictions about the direction of interest rates or inflation. However, I said, in my view he had a unique opportunity to stand out from the crowd and be the first to make his move. Yes, the real yield was low at 2.13%, but that would probably appear ridiculously high, just a few years hence.
Paul, Phil and I had talked for over an hour and, eventually, Paul agreed that it made sense to hedge – not because he was convinced the real yield would fall, but, rather, because he recognised that this entire thing was about risk management. And it was his job to manage risk. In the end, it was as simple as that.
The next morning, at 11:00 on 2 December 2003, I ran through the minutiae of the transaction details with Paul: it involved purchasing a £600 million, thirty-year, compounding, zero coupon interest rate and inflation swap transaction, by which means Friends Provident Pension Scheme transferred its entire market-related liability risks to Merrill Lynch.
It was a team effort. Whilst I was executing the transaction directly with Paul on the phone, RobertGardner and Phil Rose were checking and monitoring a multitude of market levels and speaking constantly to our inflation swaps trader and co-pilot, Jonathan Mitchell. Jonny’s job was to hedge the bank’s huge open position in the market immediately after execution. Coming up to Christmas, the market was thin and patchy. That makes long dated swaps extra volatile, and large trades are hard to execute. A bit like trying to land a 747 in a newly ploughed field. To say he did an amazing job would be an understatement.
Paul Cooper and his boss, Graham Aslet, along with the pension plan trustees and their advisers at Towers Perrin, as well as the board of Friends Provident, had made history. Over the previous two years I had presented the hedging transaction to well over 100 pension funds and corporations but only these guys had been forward thinking enough to actually do it. It was no mean feat on their part.
In the following weeks, the real yield began its steady, terrifying, eight year descent to 0% and below.
As it did so, the mark to market value of all defined benefit pension schemes’ liabilities soared, and, in the case of Friends Provident, the swaps which Paul Cooper had bought for the scheme, also soared – in equal and opposite value. It was awesome to behold.
The swaps were collateralized – which just means that as the value of the pension scheme’s new hedging swaps rose, Merrill Lynch (as counter-party to the scheme) was obliged to pledge and transfer cash and bonds of equal value, by way of security. At one point, shortly after we did the transaction, the real yield was falling so fast, and we were pledging so much collateral each day, that a guy in the Collateral Department called me at my desk:
We’ve never had to post this much collateral so regularly on any transaction before, he said. The swaps are rising [in value] by a million pounds every day. Is this really how it is supposed to work?
Yep, I replied,this is exactly how it is supposed to work. It’s a beautiful thing. And that’s why, one day, people in the know will talk about Mr. Paul Cooper and his gutsy decision to go against all popular opinion to the contrary; to fully hedge his pension scheme’s liabilities at a time when the real yield was already low. That’s what makes him an all-action actuarial hero.
The guy in the Collateral Department sounded bemused.
I guess we’ll be hearing more about this guy, then? he said.
I guess you will, I replied.