Treasury will want to ensure no default regardless of the actions of the politicians. There are a couple of ways out.

1. They could do a voluntary exchange with the Fed, where by US T bills are exchanged for bonds. The old issue is retired at par. The new issue is a par instrument issued at 500 dollars, say.

a. The debt ceiling is respected since the face value of the debt is constant.

b. The transaction generates cash for the treasury.

c. The Fed gets shafted but then its just more QE anyway.

d. We have to worry about the legality of the transaction to see if any CDS will be triggered. My best guess is no. Even if there was a technical trigger, which I doubt, since the voluntary exchange actually disadvantages the participant (the Fed), under cram down rules, the other bond holders not involved in the exchange are actually better off than the Fed and therefore will have no legal recourse or cause for complaint under bankruptcy law.

2. Treasury could create an asset and sell it. I am slightly uncertain about the legality but I think it works.

a. A predetermined proportion of tax receipts is paid into a newly created, wholly owned subsidiary of treasury.

b. Equity in this subsidiary is sold for cash.

c. It could be argued that

i. A pledge of future cash flows constitutes a debt obligation. However, since the obligation is to a wholly owned subsidiary, I think this argument may fall.

ii. The pledge of current and future cash flows to the subsidiary may constitute fraudulent conveyancing under bankruptcy law. However, I would argue that US treasuries are senior unsecured claims that carry no covenants controlling the creation of senior or other liabilities in the capital structure of the treasury, and, that the solvency of the treasury is indeterminate anyway, since its largest asset is the capitalized cash flow from tax receipts.

iii. In effect, what treasury is doing is selling assets to fund current liabilities. It, however, has to structure the asset into saleable form. In this case, capitalizing its tax revenues.

With the above 2 devices. Jack Lew would not have to worry that the strategies employed by the Republicans and Democrats may accidentally trigger a default. I cannot help but suspect that such contingencies are already in place. While nobody wants a default, the strategies employed by the players may not be ‘trembling hand’ robust. Accidents can happen and we can’t very well have a silly mistake taking us back
to barter.

Oct 17 is D Day. If the debt ceiling is not raised, there is the possibility of a US default. The consequences are quite catastrophic, to such an extent that it is almost inconceivable that the US treasury will allow it to happen, despite the combined efforts of the Democrats and Republicans. Why is it so inconceivable?

US treasuries are the most common form of collateral for most collateralized lending and derivatives. The ETF market would be at risk since a significant proportion of ETF’s are synthetic, meaning that their portfolios consist of a large dollop of US treasuries collateralizing total return swaps. Guess what the investment banks and structurers who are given that collateral do with it? They rehypothecate it, using it as collateral for their own swaps and borrowing.

The elephant behind the drapes is the repo market. Domestic repo is some 4.6 trillion USD in size. And collateral can be rehypothecated, meaning it can do several turns and thus securitize a multiple of the initial notional exposure. In Europe the repo market is some 6 trillion USD in size. That’s a combined 10 trillion USD of collateral. Not all, but a majority of it is US treasuries. But the impact is massive because this collateral gets turned over almost daily. Repo is mostly an overnight market. Longer dated repo exists but is small in comparison. Ex the US and Europe, repo market sizes are hard to come by because the deals are bilateral, off exchange agreements. Given that US treasuries are rehypothecated, the damage is not limited to the stock of collateral. A default by the US government would trigger margin calls or asset sales. There is no other market sufficiently large and liquid to replace US treasuries as collateral. There might be a exodus to bunds and gilts but there are limits to what those markets could absorb. Agency mortgages are sovereign risk by construction and would also lose their status as good collateral. This would additionally hurt the US domestic funding market but cause less international damage.

But by then all this would be academic. Global finance would grind to a halt as the collateralized lending market seized up. This is the scenario that is so catastrophic that it makes it inconceivable that the US treasury would allow a few fisticuffs between Congress and the White House to cause a default. The question, therefore is, how can it avoid default in the event that the debt ceiling is not raised.

How do you raise cash without creating a liability? This lies in the realm of the financial engineers. Perhaps future cash flows cannot be pledged in return for cash, but they might be sold, for cash. Thinking out loud, and out on a limb, it is possible that a legal route can be found so that future cash flows of the government could be cash trapped in an SPV and the equity of that SPV, can be sold. Such equity would be valued using a DCF methodology with an appropriate discount rate. It smacks of debt issuance, but it isn’t. Not really.

Since the financial crisis of 2008 it was patently clear that regulators would begin to regulate banks as utilities. Since then there has been a steady and gradual reanimation of the Glass-Steagall act, albeit not in a single legislation; this in a series of fragmented but correlated measures including Basel 3, Solvency 2, Dodd-Frank and the Volcker Rule. Henceforth, banks will be focused on their role as conduits and intermediaries of credit and funding and step away from principal activities and risk taking. Banks will be going back to basics, as it were. This wave of banking system reform is likely to be gradual and sustained, providing interesting investment opportunities. The complexity, multi jurisdictional, multi regional nature of current banking regulation will make a quick repeal such as was done to Glass Steagall, difficult and highly unlikely. The trend to greater regulation is therefore expected to be protracted and long lasting.

In the immediate aftermath of the crisis it was expected that banks would have to reorganize themselves by way of asset sales. This expectation was wrong. Asset sales would have decimated balance sheets and annihilated bank capital. Regulators and banks concluded, quite rightly, that liability solutions would be more pragmatic. The raising of bank capital and other capital solutions such as regulatory capital relief and accounting stratagems were more effective in stabilizing balance sheets while markets and the economy were given time to heal. Only once markets and economies had stabilized could asset solutions be implemented. We are now in the early stages of this phase. Some significant capital was raised in the past 2 years to take advantage of this opportunity, which now seems premature. The opportunities will now begin to present themselves. For funds still within their investment periods and with spare capital, this could be an exciting period.

Not all asset sales are stressed or distressed assets. As banks consolidate their businesses, spin outs of going concern business units are likely. Not only will prop desks be forced out through capital starvation and closure, but non core businesses are likely to be spun out as well. Banking regulation will render synergies difficult to realize or monetize. Expect energy trading and storage, real estate, asset management, and other non core businesses to be sold off.

Bank’s emergency capital structures will likely be restructured now that the state of emergency has abated. Two related themes are at play here. Firstly, emergency capital structures are likely to be sub optimal for the business. Certain types of bank capital have been or will be reclassified as debt rendering them expensive. Issuers would like to retire such liabilities. Retiring such liabilities will require funding. Banks with recourse to capital market funding will do so by issuing new securities. Banks with limited access to markets will seek structured solutions. Secondly, emergency capitalizations were funded with public funds, read taxpayers’ money, a politically sensitive source of funds. The continuation of such public financing is not politically sustainable and will be rolled back as soon as conditions allow. With the current stability and growth in the developed markets, the epicenter of the financial crisis, it is an opportune time for the withdrawal of public funds. This has to be refinanced. Private funding vehicles are in a position to profit from providing capital solutions to the banking industry, and to the public coffers as well.

As bank’s activities become more regulated and narrow, many activities undertaken by banks will need to find new sources of capital. The shadow banking system is not homogenous but is rather a collection of disparate businesses designed to augment the banks where they were or are unable or unwilling to venture. If economic growth potential is to be realized and financed, the economy will need to turn to the shadow banking industry. Without access to deposits, the shadow banking industry is less likely to come under the same scrutiny or increased regulation as banks. At some stage, regulators may want to address the systemic risk of the shadow banking system. This is a much broader subject. The investment implications are that opportunities will arise for private funding vehicles to finance economic growth and obtain an attractive return in the bargain. Direct lending, private equity, venture capital are examples of private funding vehicles operating outside the regulated banking system.

Securitizations are a huge part of the shadow banking system, in large part created by the banks themselves in their efforts at balance sheet and profit optimization. The US mortgage backed security market is one of the largest single asset markets in the world. While securitized products were at the centre of the financial crisis and have thus derived a questionable reputation, the technology remains highly useful, if not abused, or mismanaged. The regulation of banks is likely to shift the burden of financing to securitizations. Provided such products are properly structured and managed, some significant risk will be transferred away from the fractional reserve banking system. At the same time, these products provide investors with potentially more efficient and specific investment instruments for their investment strategies.

The success of financing the economy will depend on the success of distributing these alternative investment products in a way that is clear, fair and not misleading, to investors for whom such investments are suitable. This will not be easy. For the intermediaries and fiduciaries, the complexity of such markets and assets provide ample opportunity for generating attractive risk adjusted returns.

Good investment and trading practice is that you always have a thesis and the thesis implies certain milestones, and profit and loss levels. If the milestones are not met, and the thesis is unchanged, even if profit targets are met or exceeded, one should reassess the trade, preferably cutting it while the reassessment is taking place.

I have long held that the US economy was on a sustainable growth path and that the level of growth would be low, circa 2% long term trend rate. This is a view held since October 2011. With the continuing recovery, one would reasonably have expected an eventual roll back of unconventional policy involving the large scale asset purchases by the Fed. QE tapering was therefore a positive signal, in my view. With the telegraphing of QE tapering, the moderation in the pace of Fed asset purchases, my view was that there would be some significant weakness, despite the advance signal from the Fed, and that this would be a buying opportunity. The prevarication by the Fed has meant that one of the milestones in my investment thesis, a particularly important one, had been missed. Regardless of the profit or loss situation on the trade, I would take it off the table. Do I think the US equity market will rise further? Yes, probably. However, my initial thesis implied an important milestone that was missed. This is a matter of investment discipline.

I maintain the view that the US economy is on a path of sustainable growth. That the new equilibrium trend growth rate is now closer to 2% than to 4% is likely to be confounding the models used by most forecasters and the Fed. This is a contributing factor for the Fed to be likely to be more accommodative than it needs to be on an ongoing basis, at least until it revises its long term growth rate.To be clear, I do not see a weak economy and I do not see the Fed as interpreting it as such. The delay of QE tapering is likely in respect of a confluence of a couple of risky events which the Fed would like to see out of the way before it moderates its asset purchases. Topical issues like the German elections and the uncertainty around the possible structure of the coalition, the impending fisticuffs over the US debt ceiling and the historical turbulence around October time, have probably led the Fed to postpone QE tapering by a month or two. There may be some weakness in the market then that may be worth buying into.

We began to be bullish US equities 14 Oct 2011. On 13 Jan 2012, we called a buy on Europe across all risk assets on the back of the ECB’s unprecedented 3 year repo facility. This was a bit early and required the investor to sit through quite a lot of volatility. Some would have folded in May 2012 on the adverse price movements, but it turned out to be a profitable trade after all.

We continue to like the US and Europe. US equities, while still attractive on the back of a recovery are no longer as cheap as they were a couple of years ago, and are also more advanced in the profit cycle. While we continue to maintain exposure to the US, we now turn our attention to Europe, an under-represented exposure in many investors’ portfolios.

First of all, Europe is a high risk investment. The Euro as a single currency clearly doesn’t work. Its financial symptoms have been clear enough with mini crises precipitating in the periphery of the Eurozone every so often. Greece, Italy, Spain and Portugal continue to look flimsy. The banks continue to periodically wobble. But the true cost of the Euro is yet more insidious, it is that factor markets, particularly the labour market, fails to clear. A host of issues remain unresolved and await the German election where incumbent Angela Merkel is expected to win. After that the hard work begins.

Yet for all its risks and flaws, Europe remains an attractive hunting ground for investment opportunities. A number of features make Europe stand out as a region where detailed analysis can be rewarded by the discovery of mispriced assets.

1. The global nature of its companies.
2. The heterogeneity of its economies and businesses.
3. The complexity of its financial system.
4. The complexity of its political system.
5. The length and traction of its history.

The current opportunity consists of a number of things. Europe is currently in the early stages of a recovery, much like the US was nearly two years ago. Europe had a different crisis than the US. Whereas the US leant on and broke the pole of residential housing, Europe had an unsustainable financial model and monetary system which was laid bare by sudden contraction of credit in 2008. Europe’s economic woes were and continue to be much more serious than in the US. As a result, compared with the US, Europe is still in the very early stages of recovery. Now an inspection of the broad European stock indices might make it appear as if Europe had already recovered, but these are the consequence of global companies listed in Europe pulling up the aggregate indices.

Whereas profit margins in the US are at cyclical highs, in Europe, corporate profitability remains weak. Yet investors are happy to assign multiples of 15X to US earnings and only 12 X to European earnings. Europe is facing discounted valuations on trough earnings making the market quite attractive. With a nascent recovery, profitability and earnings have a higher probability of recovering to trend levels. Markets tend to also reward such recoveries with higher multiples. The upside potential is significant.

In the US recovery, companies with high operating leverage prospered. A similar scenario is likely to occur, if the European recovery gains traction. As political systems more Socialist and labor markets less efficient, European companies on average have higher operating leverage. Even the much vaunted German companies have codetermination and labor representation on boards. Excess capacity abounds in Europe, a delaying factor in a recovery, but a boost to profits when a recovery gets underway.

While the US contemplates moderating its central bank asset purchases (QE Tapering), the ECB is expected to remain accommodative. Tightening will not be on the ECB’s agenda for some time to come. Cost of debt will remain low, especially for companies with access to the debt capital markets, while global operations provide diversified sources of revenues, making for attractive economics.

In many ways, the conditions that favor European equities may favor European high yield bonds even. Low interest rates, weak positive growth, international companies, bode well for high yield credit.

No investment is without its risks. The risks of investing in Europe, we have already highlighted. The fundamental flaw of the single currency, the Euro, will create periodic mini-crises, as markets, for goods and services as well as financial assets struggle to clear. This can be a risk as well as an opportunity. Sometimes, the best assets are found in the scrapheap.