December 15, 2011
Just when it looked like a European fiscal bargain would end the sovereign debt crisis, save the euro and stabilize the markets, the other shoe dropped. Confidence in the plan is fading with Great Britain’s refusal to take part in the deal, and a weak commitment from the Czech Republic and Sweden. This pessimism has driven the euro to new lows.
The result: dramatic swings in markets that are desperately seeking stability.
But the volatility is not caused by lack of faith in Europe’s politicians alone. These wild fluctuations are a direct result of hedge funds betting huge amounts that the European crisis will end in default.
As their name implies, hedge funds make money by hedging their bets. They make investments based upon most likely outcomes, but make other investments in case the likely outcome does not occur. If they’re wrong – as in the case of Jon Corzine’s MF Global, which bet more than $6 billion that Europe would not allow a eurozone country to default – vast sums of money can be lost. (Corzine was doomed by the looming fear that a eurozone country could go belly-up.)
According to a fixed income money manager who requested anonymity, many hedge funds are now taking the position that a default will occur. They’re buying derivative instruments called credit default swaps (CDS), or an insurance policy that banks and money managers offer for debt. If a country is unable to pay a debt, banks then pay the hedge fund an insurance payout.
It helps to think of a CDS as life insurance. As someone in my early 30s, I pay a small amount of money to an insurance company – say All State - every year in the unlikely event that I die suddenly. All State has determined that this is a good investment, because as a healthy young man the chance that I’m going to die is low. If I make payments for 50 years and the insurance company never has to pay out my policy, it's a good deal for All State. But if I die tomorrow and All State has to cut my wife a large check, it's a bad deal. All State is willing to take that chance.
But the difference between life insurance and a CDS is that the latter is traded on an open market, which means outcomes can be swayed by investors. Let’s say Greece is offering bonds with a yield of 6 percent. This means they’re willing to pay back the face value of the bond plus 6 percent interest. A hedge fund – let’s call if TFT Capital - approaches a bank – let’s call the bank US National. TFT Capital offers to buy an insurance policy, or a CDS, on $1 million of Greek debt with a 10 percent yield, 4 percentage points higher than the yield Greece is offering. But TFT doesn’t actually own the Greek debt it’s insuring against default, making its CDS “naked” – and making it’s bet more like pure speculation and less like an insurance policy.
US National takes the deal, and then gets a payment of 10 percent of $1 million, or $100,000, without having to shell out the actual $1 million to buy the debt (actual amounts are much larger). If Greece defaults, US National has to pay TFT Capital $1 million plus 10 percent interest. If Greece makes the payment, then US National gets to keep the insurance payment the hedge fund made without having to take over the underlying security from TFT.
“It’s the same thing
as a run on a bank.
It makes it impossible
for Greece to refinance
itself. It’s a death spiral.”
So TFT Capital and US National have now created a market where Greek bonds are selling with a yield of 10 percent without either party ever having to purchase the Greek bond. As the market is now demanding 10 percent interest payments as opposed to six, Greece has no choice but to offer the bonds at the higher interest rates. This reduces their ability to raise money in the short term, as well as their ability to pay money back in the long-term.
As long as banks are willing to offer insurance on European debt – meaning they believe that this crisis will be solved -- hedge funds can drive up the price of bonds, making it harder and harder for Greece to pay its debt. (If Greece does fail, large banks will suffer losses, but will have their bets in favor of Greece hedged elsewhere. Smaller banks with pro-Europe positions won’t be so fortunate). Because of the large size of many hedge funds, they are able to take large positions and manipulate prices higher and higher. The top 225 hedge funds in the United States hold $1.3 trillion. The largest, Bridgewater Associates, has $58.9 billion.
With size like that, hedge funds are able to cause the violent fluctuations world markets have experienced this year. If a hedge fund takes a sizable position betting against Greece, other investors take notice and make their own bets against Greece. Soon markets are in a panic that Greece is on the verge of default.
“It’s the same thing as a run on a bank,” the fixed income money manager said. “It makes it impossible for Greece to refinance itself. It’s a death spiral.”
As the situation grows
more dire, the market
for hedge funds betting
against Europe is growing
larger, pushing the euro
zone to the breaking point.
Greece has already peered over the precipice numerous times. However, the European Central Bank has not declared Greece’s inability to pay its bill a default to prevent hedge funds from cashing in.
On Dec. 1, the European Parliament banned naked CDs to prevent European hedge funds from taking runs at individual countries. But the EU has no power to stop American firms.
William Black, associate professor of economics and law at the University of Missouri – Kansas City, said that some hedge funds are likely making bets that Greece and other European countries will pull through the crisis. But as the situation grows more dire, the market for hedge funds betting against Europe is growing larger, pushing the euro zone to the breaking point.
“Hedge funds add no value to the world,” Black told TFT. “If they do anything positive, at best, they make exceptionally wealthy people even wealthier and there isn’t a whole lot of societal value in that.”
Hedge funds aren’t required to reveal their market positions. As Black said, “You really can’t take statements at face value on issues like this.” Bloomberg recently reported that CQS UK LLP, a London-based hedge fund that manages $11 billion, is making bets that the crisis spreads well beyond Greece. George Soros, who managed Soros Fund Management, has also publicly blasted Europe’s ability to contain the crisis.
“We are on the verge of an economic collapse which starts, let’s say, in Greece, but it could easily spread,” Soros said on a panel in Vienna in June. “The financial system remains extremely vulnerable.”
Black said hedge fund investments have quickened Europe’s slide toward default. Their positions have helped to spread the contagion from Greece, whose economy is small, to larger, more important countries like Italy.
These investments are “akin to chumming the waters. One or more of these currencies get in trouble, folks start piling on and betting against creates the self-fulfilling prophecy.”