Sum Of All Fears: U.S. Default And Repo Market Collapse

By Tom Yorke

The U.S. appears to have kicked the can successfully down the road after House Speaker John Boehner extended an olive branch of sorts in its dispute with the White House over reopening the government and raising the debt ceiling.

Still, the mess in Washington is threatening to make summer of 2011 and the downgrade of US debt just Part I of this drama. All sides of the aisle seem to be engaged in one form of grandstanding or another.

The real issues get clouded at every opportunity. Is the drop-dead date October 17th, or is it really November 1st before we technically "hit the wall", is just one example. aIn short the lunatics had grabbed control of the country and it's just sad, but thankfully now cooler heads seem to have prevailed.

The spike in the US equities markets on October 10 (over 2% in the Dow, S&P 500, and the Nasdaq) dramatically underscore the desire of everyone outside of the Washington Beltway to make sure the adults stay in charge. I am now certain (finally) they do not want to fail with this meager charge. A simple extension of the debt ceiling for six weeks as the House GOP proposed is a possibility, but we have been disappointed before.

I'm grateful, however, for the government shutdown for just one reason…no employment or non-farm payroll numbers this month. Given this statistic is subject to significant revisions after its original release, the final, thrice revised number, may ultimately be much better than the original consensus estimate.

Christine Lagarde, the IMF'S Managing Director, chimed in about the Washington debt ceiling mess and its impact on the global economy and financial markets.

I read something recently about how some large "prime brokers" (think of them as the willing lenders against suitable or liquid securities held as collateral) told hedge fund customers that US Treasuries may not be accepted for collateralized loans known repurchase agreements or repos.

If you can't sleep some night, try researching the role of repo's in the world of international securities and settlements. Short version: Repos highly specialized lending agreements. Think of them as the "engine room" of our financial markets that enhance the liquidity for all investors globally and dramatically.

US Treasuries have long been the Rolls Royce of collateral, and to think they might somehow not be accepted as collateral for institutional short term financing is very scary. The markets would likely totally seize up and cause unbelievable carnage. The members of the Lunatic fringe in Washington DC, pushing us willfully closer towards default, should be forced to spend some time on a bond trading desk, so they at least they get a good look before they leap.

The change of command at the Fed could not have been handled any worse, even if it were scripted by some Hollywood B movie producer. Specifically, Janet Yellen nomination as the next Federal Reserve Bank Chairman was handled poorly.

The good old boys thought they could just push Yellena aside, shove their man Larry Summers in line for the job, but realized late in the game they were sorely mistaken. aThey pulled a rabbit out of their hats, and partially saved the day. aDemonstrating that politicos can sometimes do the right thing, even if they don't really want to, so they end up snatching victory from the jaws of defeat.

I attended the EDHEC Risk Institute conference ain New York arecently. The event is a gathering of academic researchers and their "quant" followers to discuss results of various studies in the world of securities research. It's a bit thick for the uninitiated, filled with long speeches and PowerPoint presentations of the latest academic research in risk management and investment returns.

The conference covers many topics, passive vs. active investment, indexing and volatility strategies, asset allocation, and other optimized investment strategies. The term "Smart Beta" or "Beta 2.0" were thrown around quite frequently, as well the phrase "dumb Alpha" ( meaning accidental incremental returns) versus "smart Beta" (basically planned or improved passive methodologies for investing.)

The conclusion: Diversified investing, combined with systematic rebalancing strategies, outperformed their benchmarks significantly over longer time horizons. Fifteen years was the most common period cited, meaning 2-3% more in total returns.

This can mean a substantial dollar value differential at the end of the designated period. Additionally, they also had lower risk profiles, but (always has to be one) they often went through periods of underperformance relative to their benchmark. Translation: Long term, diversified investing with systematic rebalancing delivers outsized returns over longer time horizons.

The investments discussed are held in client accounts as of September 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.

Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures. For information about Covestor and its services, go to http://covestor.com or contact Covestor Client Services at (866) 825-3005, x703.

Tom Yorke

Tom Yorke

Oceanic Capital Management, LLC is a registered investment adviser based in New York. I am Tom Yorke, Oceanic's Managing Director.

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