Markets are generally efficient in aggregate and over time. Markets can be inefficient in parts or for periods of time. Do I really believe this? Yes, provided they are proper markets by which I mean that there are sufficiently numerous independent participants, neither of which has sufficient individual influence over pricing.

Most of the familiar asset types exhibit these properties. Equity markets are a good example. So are corporate credit markets. The persistent performance of a small group of hedge fund managers, and the disappointing performance of the significant majority of their competitors is instructive. Successful equity hedge fund managers are rare. Credit managers tend to display more persistent out performance. The liquidity, symmetry of information, completeness of markets in equity markets tends to level the playing field. They also make inefficiencies small, relative to background noise, complicating the job of the equity investor. Here is another point. Every market has a level of background noise. Inefficiencies have to be larger and more persistent if they are to be captured by an investor. If the inefficiencies are too small or last too short a time, then by definition these markets are too efficient. This could be one measure of the efficiency of a market. That some investors are able to repeatedly beat the market implies that there are inefficiencies but that they may not be obvious enough for the majority to identify or capitalize on.

Cross asset inefficiencies are an example of how apparently efficient markets can be inefficient because they are in fact incomplete. Capital structure arbitrage is evidence of such inefficiencies. Because efficiency in equities and bonds are policed by different constituents whose pricing models do not look across asset classes, the valuation between different parts of a company’s capital structure may be mispriced and provide the suitably equipped investor arbitrage or relative value opportunities. This strategy is especially topical under the current cosh of increased regulation in the form of Basel 3, Solvency 2, Dodd-Frank and the Volcker rule. The best policing of capital structures used to be the proprietary trading desks of the investment banks. With increased regulation, prop desks are being shrunk or closed, reducing the amount of capital policing cross asset no-arbitrage conditions in the markets. The opportunities for arbitrage and relative value are greater now than ever before. In other words, markets are a lot less efficient these days.

There are other reasons why a market may be persistently inefficient. The existence of one or a group of participants with disproportionate influence can distort pricing. A simple example is a regulator or central bank. Under what was apparently regarded as normal conditions, central banks may unilaterally determine or influence the level of short term interest rates. While this is already a deviation from the assumption of market determined prices an even greater departure is if the said central bank additionally influences other maturities along the yield curve, for example through the open market purchases of government bonds we have come to call Quantitative Easing or QE. Under these conditions the market is far from perfect and no-arbitrage pricing should not be expected to hold. Investors trading on the assumption of efficient pricing are likely to be confounded.

Extending the complete markets argument for inefficient markets, one could argue that price distortion in one market can affect prices in other markets. A current example is equity markets. Investors consider equity valuations reasonable on an equity yield gap basis, that is relative to US treasuries. If, however, the yield curve is being artificially suppressed by the actions of the central bank, such as under the unconventional monetary policy we call QE, then equities are vulnerable if the central bank were to reduce or stop their purchases of US treasuries and the yield curve was to find its natural level.

Another instance where markets are temporarily inefficient are times or high uncertainty and turbulence where information is insufficient for the market to digest and interpret. Times of crisis and near crisis often lead to the inversion of credit default term structures, for example, making it more expensive to insure against default over a shorter period than over a longer period. US treasury bills may at times trade at higher yields than the unsecured LIBOR market in a recent example, when default by the US treasury seemed possible, albeit highly improbable.

In some markets, imperfections are more prevalent or persistent. Securitized markets such as mortgages, auto loans, student loans, and credit cards are a good example. Complexity of products, market conventions, market culture and regulation make the securitized products market a highly peculiar one. The highly contrived nature of the products being traded are the root of the overall complexity of the market, if it can even be called a market. The highly politicized nature of the underlying assets in which the derivative products are based also invite complex and confusing regulation driven by the confluence of politics, socio-economics and commercialism. One of the results is one of the largest, most liquid asset markets in the world: agency mortgage backed securities. Yet size does not an efficient market make. The best traders in mortgage markets are those who have been involve in the regulation or the industry, the production of the securities, the distribution of product and the origination and management of the underlying assets being securitized. They are bonds indeed, but not as we conventionally know it. Fixed income investors uninitiated to the peculiarities of the MBS market but lured by the high yield, high ratings, often struggle to trade an entrenched club of insiders.

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.