So Much For That Big Fat Greek Payday?
The negotiations over the Greek debt haircut are becoming increasingly suspenseful, with euro-zone finance ministers and the IMF pushing investors to accept greater losses. Hedge funds, more than any others, stand to profit, and are betting that the voluntary debt rescheduling will fail.
Who will bleed for Greece? For weeks, private creditors like banks and insurers have been trying to negotiate a debt rescheduling with the country without success. Even when they seem close to agreement, it remains unclear if all creditors are on board. In particular, hedge funds that own Greek bonds could have a significant interest in ignoring the results of the negotiations, instead preferring to focus on an official national default.
Bank representatives assume in the meantime that many hedge funds are not really interested in an agreement. With a controversial investment strategy they have assured themselves of profiting with either a low level of Greek bad debts, or a complete Greek bankruptcy.
At issue are Greek bonds with a total volume of about €200 billion. How many are owned by hedge funds is unclear, but the amount is estimated to be about €70 billion (including other funds).
The bondholders are expected to voluntarily give up 50 percent of their claims. Another 15 percent is to be compensated with either cash or secure bonds of the European rescue fund EFSF. The remaining 35 percent should come in the form of new Greek bonds, that will likely reach maturity in 30 years.
The amount of money the creditors will actually have to give up depends on the interest rates on the new bonds. The Institute of International Finance (IIF), which is leading the negotiations with Greece, is insisting on an average of at least four percent. The euro-zone finance ministers and the International Monetary Fund (IMF) have instead insisted on rates lower than four percent, in order to make the burden on Greece more bearable. The banks calculate that this means they would actually lose closer to between 70 and 80 percent of their claims, and they are balking.
'Not Worried About Their Public Image'
For some hedge funds, the fight over interest rates has given them more incentive to push for a breakdown of the proposed plan. Officially, they are in the same boat as the banks and insurance companies. But in reality their interests are vastly opposed.
"Hedge funds don't need to worry about their public image," one banker says. Their reputation has already been destroyed. Therefore, they can be relatively cavalier in gambling with the possibility of a Greek bankruptcy.
In an internal analysis of the German Savings Banks Association (DSGV), which represents the public banks, the hedge funds come off fairly badly. With the financial investors "only the performance" is most important. There is "hardly a political or economic corrective factor," such as long-term customer or contractual relations, the analysis says. Therefore, "one can conclude that they are not really interested in an actual Greek rescue."
Unlike the creditors who have long held Greek state bonds and definitely stand to lose in the case of a Greek debt haircut, some investors have only jumped in over the past few weeks. They have stocked up not just on Greek bonds, but also on the related Credit Default Swaps (CDS). These Credit Default Swaps guarantee the buyer protection in the event that the underlying bonds default. "This week alone there will be scores of new CDS transactions," one insider says. "And some of them at exorbitant prices."
Those who in the past few days have bought Greek state bonds worth €1 million euros and wanted to protect them against loss with CDS, would have had to pay more than €400,000 or even €500,000. And they fluctuated wildly -- depending on the news, the price of CDS rose and fell sharply. That indicates that the CDS are being used mainly for gambling.
This example shows how the calculations made by short-term investors work:
- One hedge fund stocks up on Greek state bonds. Since the market participants have long expected a haircut of 50 percent, the prices of the bonds are extremely low. They are, for example, at 30 percent of the nominal value at which the bonds were issued. The funds, for example, have bought Greek state loans with a nominal value of €100 million, but paid €30 million for them.
- At the same time, the hedge funds are protecting themselves with so-called Credit Default Swaps (CDS) against a Greek payment default. Such Credit Default Swaps are deals between two market participants. The seller agrees to compensate the buyer for losses, should the underlying obligation default, in this case the Greek state bonds.
- As long as a debt haircut for Greece has not officially been finalized, the CDS secure the full nominal value of the bond, or 100 percent. Therefore they are also very expensive and cost, for example, 30 percent of the nominal value. In addition to the €30 million for the bonds, the funds have also paid €30 million for the CDS, or a total of €60 million euros.
But there are other ways in which the poker game can play itself out, and the funds can make large profits.
- If it comes to a haircut of 50 percent, then two things would happen: The Greek state bonds would gain in value and instead of costing €30 million, run at maybe €45 million. At the same time, the CDS safeguard for the hedge funds would fall significantly in value. Therefore, the funds would only reap a small profit. This variation, therefore, is not attractive for them.
- Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.
If the Institute of International Finance (IIF) and Greece agree on a voluntary haircut, it is attractive for the hedge funds holding the CDS to simply not to take part. In this case, there are three possibilities:
- Too few of the bondholders take part in the haircut. Should more than 20 percent of the bondholders refuse to accept the negotiated conditions, the debt rescheduling could break down, and with it also likely the second rescue package for Greece. The country would be bankrupt, the CDS would be due, and the hedge funds could cash in.
- A lot of bondholders partake. Should, for example, 90 percent of the investors promise to take part, the few holdouts could emerge unscathed, and bet on Greece paying off the bonds as they mature. Hedge funds that hold Greek bonds could in this case become the classic definition of a freeloader.
- The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.
The strategy does have one snag. The hedge funds assume that in the event of a payment default all CDS providers can pay. That is by no means certain, though. The CDS papers are distributed opaquely throughout the financial system. No one knows for sure who holds them at a given time, and who, in the end, will be responsible for them.
The majority of large banks have both issued and bought CDS. The net risks are therefore officially quite small. But should only one of the larger CDS issuers turn out to have difficulty paying, a chain reaction could be possible with unknown consequences. Under that scenario, it would also likely affect the hedge funds.
Some hedge funds are preparing for a legal battle. Sarah White and Tommy Wilkes of Reuters report, Hedge funds prepare legal battle with Greece:
Hedge funds are combing through the small print of Greece's planned rescue deal with private creditors, readying a wave of potential litigation to squeeze a better payout from the country.
Most bondholders face an uphill battle in wringing a payment from Athens through the courts, but shrewd funds picking up specific bond issues with investor-friendly small print have a much better chance of succeeding.
This is so worrying those negotiating Greece's private sector deal that many are trying to keep the final structure of a rescue package under wraps until it is done to prevent the funds from finding a legal edge, sources close to the talks say.
Challenging countries through the courts is a well-worn hedge fund strategy - some are still battling Argentina for payouts more than 10 years after its record-breaking default.
The closer Greece edges to a disorderly default where it imposes losses, rather than a managed one in which it agrees a deal with a majority of bondholders, the more creditors are likely to go down the legal route.
Athens is racing to cut a deal to slash its debt pile by some 100 billion euros (83.5 billion pounds) through a voluntary bond swap that would see private creditors swallow 50 percent losses.
If a deal is not in place by mid-March, when a 14.5 billion euro bond falls due, Greece may not get the funds it needs from the European Union and other lenders to avoid a managed default.
"If the path followed (in Greece) is a non-voluntary one, there will be excessive litigation," said Rodrigo Olivares-Caminal, a banking and finance law specialist at Queen Mary, University of London, and an expert in sovereign debt.
Madrid-based Vega Asset Management threatened it would take legal action when it quit the committee leading private creditors in talks with Athens last year, unhappy about the size of potential losses, sources said at the time.
One lawyer specialising in debt restructuring said on Tuesday he had been contacted by funds looking at legal options relating to Greece, while several funds also told Reuters they were weighing up strategies if they are forced to take losses.
Funds forced into losses as part of the bond swap or default have several avenues to bring a case, including the European Court of Human Rights or the International Centre for Settlement of Investment Disputes, Olivares-Caminal said.
Hedge fund tactics range widely. Many will be keen for a deal to get done and will not sue, especially if they can profit from the difference between the level of losses imposed and the price they paid for the debt in the secondary market.
Others hope to be paid out in full if enough other private creditors -- primarily banks and insurers -- sign up to the bond swap.
If Greece can get the go-ahead from about two-thirds of private creditors, it plans to pass laws to coerce reticent bondholders, like the hedge funds, into taking losses, sources have told Reuters.
To counter this, some hedge funds are going for defensive strategies and buying up some of the 18.3 billion euros of Greek bonds that were drawn up under English or foreign law, industry and legal sources said. These would be immune from any changes to Greek law.
The English law bonds do contain so-called collective action clauses designed to force outliers into a deal -- but they state Greece would have to get 75 percent of creditors to back a deal, most likely higher than the threshold Athens would impose in domestic law bonds in its bid to get a deal done.
They also contain precise clauses that could help hedge funds sue or eke out a settlement if they are forced into an unfavourable bond swap, because they are not being treated equally to other creditors like the European Central Bank.
The English law bonds include pari passu clauses, which mean creditors have to be treated on an equal footing and could give them leverage over the ECB, which owns around 45 billion euros worth of Greek bonds bought in the secondary market.
So far the ECB has shown unwillingness to participate in the bailout, but if Greece can succeed in forcing funds to take losses, the holders of these English law bonds could argue the ECB's immunity is unfair.
One big worry is that hedge funds could buy up enough of the English law bonds to block the clauses from being triggered for specific bond issues, although none of the sources contacted by Reuters had evidence of this happening yet.
That would make an overall agreement with private creditors very hard to reach, and give hedge funds ways of resisting further deals if Greece were to default.
Suing bankrupt governments is still a risky game, however. Funds such as New York-based Elliott Management and its affiliates, which specialise in these types of tactics and have won court cases against Argentina, are still chasing the money they are owed.
That debt restructuring saga was also easier for hedge funds to play as the bulk of the bonds were under U.S. law, limiting Argentina's influence over them.
One hope in the far tougher game that is the Greek negotiations is that Athens, keen to restore its reputation as a reliable debtor, might prefer to settle with reticent creditors than head into years of courtroom battling.
That would echo strategies employed by Ireland to deal with unhappy bondholders when it restructured the debt of its banks.
"The primary strategy is unlikely to be a court judgement after protracted litigation," said Steven Friel, a litigation partner at Brown Rudnick.
"Bondholders are much more likely to work towards settlement, if necessary using the threat of litigation as leverage to negotiate a better deal."
Finally, Landon Thomas Jr. reports, Hedge Funds Scramble to Unload Greek Debt:
So much for that big fat Greek payday.
Hedge funds that loaded up on Greek bonds in the last month — betting on a quick gain — are now scrambling to sell those holdings, fearful that European policy makers will force them to take a deep and binding haircut on the debt.
But walking away from the trade may not be that easy. While the money managers had little problem snapping up the bonds from European banks eager to sell, the pool of potential buyers is drying up.
Hedge funds have few options. Although talks between Greece and its bondholders have stalled, European officials are pressing for a deal by the end of this month. Under the proposed debt restructuring plan, hedge funds and other private sector creditors would have to incur losses of 50 percent or more — whether or not the bondholders agreed.
“I think it’s going to be take it or leave it. And if you do not participate you will get massively beaten up,” said one hedge fund holder of Greek debt, alluding to the unpleasant prospect that if he did not take the deal — and the steep loss in value, or haircut — he would end up with nearly worthless Greek bonds and with virtually no legal protection.
The situation represents a significant shift in how Europe has approached the issue. Last year, when the idea of a Greek debt default seemed a remote possibility, the private sector agreed to a “voluntary” 21 percent loss on its bonds. The fear was that forcing mandatory losses would lead to a disorderly default and scare investors off European debt altogether.
But as Greece’s economic problems have worsened and the need for debt relief has become more acute, Europe, particularly Germany, has come around to the realization that the private sector must take a deeper loss. In a sign of the new direction, the region’s leaders have begun discussions with the European Central Bank on an arcane debt swap that would strip 55 billion euros ($72 billion) of Greek bonds from the central bank’s portfolio, thus removing the possibility that the central bank might share losses with the private sector in a debt restructuring deal.
Now, the smart money isn’t looking so smart. Starting in December, the counterintuitive, go-long Greece bet was one of the more popular pitches made to hedge funds in New York and London. Investment banks — Merrill Lynch was particularly aggressive in recommending the trade, investors say — argued that even though Greece was nearly bankrupt, those who bought the paper maturing in March could double their money when Greece received the next installment of its bailout, due that same month.
The theory was that the bulk of that money would be paid to bondholders to keep Greece solvent, just as was the case with past payments from the European Union and the International Monetary Fund. Greece might well restructure its debt, the bankers said, but added it was likely to happen later and would not affect the March payout.
The pitch worked. In the last month or so, hedge funds purchased an estimated 4 billion euros ($5.2 billion) of beaten-down Greek bonds that mature on March 20.
But the bonds have gone from bad to worse. “There was a lot of volume going in, but not a lot going out,” said one broker, speaking on condition of anonymity. The broker said prices for March 2012 bonds had slipped to about 35 cents on the dollar, from approximately 40 cents to 45 cents.
Brokers estimate that of the 14.5 billion euros worth of these bonds outstanding, the largest holder is the European Central Bank, which bought the securities in 2010 at a price of about 70 cents in an early, ultimately futile, attempt to lift Greece’s failing bond market. The brokers say that 4 billion to 5 billion euros of bonds are owned by hedge funds at an average cost of about 40 cents to 45 cents on the dollar, with some of the larger positions being held by funds in the United States that have large London offices.
“It was a very binary trade,” said one hedge fund executive who listened to the pitch but passed. “If you got paid, you double your money in a month. But you may also look like an idiot.”
As I stated, it's crunch time for Europe, and politicians will ram this deal down hedge funds' throats. Smart hedge funds will take the offer and walk. Those foolish enough to sue Greece will be taught a lesson. There will be no big fat Greek payday for them.
Below, Nobel laureate Michael Spence, a professor of economics at New York University, talks about the European debt crisis. He speaks with Tom Keene on Bloomberg Television's "Surveillance Midday" at the World Economic Forum's annual meeting in Davos, Switzerland.
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