Teaching Hedge Funds a Lesson?

David Paul reports in Huffington Post, Politicians Seeking Upper Hand Over Hedge Funds in Greek Bailout:

Negotiations to avert a default by Greece continue to move haltingly. The closer the parties get to a resolution--presumably replacing existing short-term debt with new, long-term bonds with a reduced coupon--the clearer it is becoming that a solution may require 100% participation of bondholders while sustaining the illusion of "voluntary" investor participation.

The holders of the Greek debt range from European banks to hedge funds. The European banks--for decades among the titans of the world financial system and the envy of U.S. banks--have been a shadow of their former selves since 2008. Many were essentially insolvent in the wake of the 2008 collapse, and only survived through a combination of sovereign guarantees, public injections of capital and actions by the U.S. Federal Reserve Bank.

Those banks are the largest holders of Euro-denominated sovereign debt of Eurozone members, in large part because they viewed that debt as carrying an implied guaranty--much as U.S. banks viewed the mortgage-backed securities that were their undoing--and because those bonds were eligible collateral for their borrowing from the European Central Bank. In a larger sense, however, those purchases reflected the extent to which the banks have become an integrated part of the public policy apparatus of the new Europe, where the boundaries between the public and private sectors have becoming increasingly blurred.

Hedge funds, on the other hand, live with no such ambiguity. Hedge fund buyers of Greek bonds are in it for financial gain. If a fund trader buys a medium-term Greek bond, they do so in anticipation of being able to sell that bond in the future at a higher price or in the extreme case holding the bond until it matures at 100% of its par value. To effectively protect against downside risk, they might concurrently enter into a credit default swap that would pay off in the event Greece were to default on its payment obligation. Ideally, a well-structured trade provides an upside to the hedge fund regardless of the outcome for Greece. Heads they win, tails they win, and only the math would tell you which way they would win more.

But in the new world order, things are not so simple. There are many participants involved, and each has their own set of metrics for a successful outcome of the Greece workout. The proposed resolution would provide for a swap of currently outstanding Greece bonds for new bonds that would pay out over a longer term, at lower rates. In theory participation is voluntary, but clearly some are kicking and screaming as they seem to be voluntarily coming to the table.

For the banks, the proposed swap is not such a bad outcome. First, because their holdings are of both short and long-term bonds, and based on the complex portfolio accounting, what they lose on swapping their short-term bonds in the deal, they make up in part at the long end. Second, as part of the complex public-private Euro-policy apparatus they have been told by their new political masters to play ball. But finally, and of critical importance, the European banks want to avoid an official default--or "credit event" as defined by ISDA, the International Swap Dealers Association--on Greek debt, as those banks are the primary providers of the credit default swap insurance purchased by the hedge fund community, and they want very much not to have to pay out on those derivative contracts.

For Greece, the objective is clearly to survive the restructuring with a balance sheet that causes as little domestic pain as possible, and to retain access to new borrowing going forward. To any rational observer, this outcome seems counter-productive, as it is hard to imagine that such continued market access for new borrowing will not lead all of the parties back to the table for a new workout down the road. Same script, another year.

For the hedge funds, this may be, to use that paternalistic cliché--a teachable moment. The banks seem to be getting out of the deal what they need--putting off a hit on their capital and avoiding a credit event under their credit default swap exposure. For its part, Greece seems to have garnered increasing leverage the longer the negotiations drag on, at least in part through its threat to recast the terms of the bonds. The bonds were sold under Greek law, and someone seemed to have realized that the Greek parliament could have the power to unilaterally change the terms of the outstanding obligations. It is hard to fathom that such an action would be legal, but no doubt Greek legislators would be only too eager to vote on the matter. It is the hedge funds that seem to have ignored the extent to which rules in the financial markets are increasingly subject to political intervention, and they may find themselves to be the odd man out.

The deal on the table is evidence of the growing interplay between the financial markets and political forces. Like the GM bondholders, the hedge funds are finding themselves subject to massive political and coercive pressures to consent to a workout that takes away both the upside that they thought they owned and the downside protection that was their fallback. In the most ironic of twists, hedge fund managers have threatened to sue in the European Court of Human Rights to prevent the usurpation of their economic rights through the proposed "voluntary" restructuring. Perhaps they are right on the merits, but it may be that trading and making a profit on the life and death of nations is not going to be as easy as it once seemed.

Early on, the new, dynamic interaction between the private financial markets and the political world was evident in the enormous pressure felt by Greek politicians to vote to cut public sector salaries, pensions and services. The worm seems to have turned, and now it appears that the Greek politicians are not as dumb as they seemed, nor the hedge fund traders as smart as they thought.

Indeed, Greek politicians are not as dumb as they seemed and if I were advising the Greek coalition government and EU politicians, I'd tell them straight out: screw the hedge funds and tell them this is the final offer, take it or leave it (Update: Eurozone finance ministers reject private bondholders' Greece offer).

All the doomsayers who claim default is Grece's only option, warning of "CDS triggers", are delusional. Won't happen in a million years. Why? Because it will wreak total chaos on the global financial system and the politicians and banksters will burn hedgies before they let that happen. Hedge funds can bitch and scream all they want, at the end of the day, they'd be wise to take what is being offered on the table or risk endless legal battles and huge losses.

On this last point, Drew Benson of Bloomberg wrote an interesting article, Billionaire Hedge Funds Snub 90% Returns:

Billionaire investors Kenneth Dart and Paul Singer rejected Argentina's defaulted debt restructuring in 2005. Since then the securities have beaten returns on emerging-market bonds, global stocks and oil.

While Dart's EM Ltd. and NML Capital, a unit of Singer's Elliott Management Corp., seek a U.S. Supreme Court hearing to help their lawsuits aimed at recouping at least $2 billion they say they are owed, creditors who accepted the 2005 offer of 30 cents on the dollar have received returns of about 90 percent, according to estimates by Morgan Stanley. The Supreme Court asked the Obama administration last week for advice on whether it should hear an appeal from the hedge funds.

The restructured securities have outpaced the 70 percent return on emerging-market dollar debt, 24 percent gain in global stocks and 75 percent rally in oil as Chinese demand for Argentine soybeans helped propel growth. Dart and Singer, who used similar legal tactics to make money during Brazilian and Peruvian restructurings in the past two decades, have been unable to seize Argentine assets that could satisfy their demands.

"Tendering in 2005 was by far the best option for investors," said Alberto Bernal, head of fixed-income research at Bulltick Capital Markets in Miami. The holdout funds "will make money, but it's debatable if they'll make more than if they tendered before."

Two Restructurings

Argentina, which defaulted on $95 billion of bonds in 2001, offered foreign investors a choice of par bonds due in 2038 or discount debt maturing in 2033 in the 2005 exchange. Warrants that pay investors based on annual economic growth were issued with the bonds as well and now trade as separate securities.

Yields on the discount bonds have fallen 102 basis points, or 1.02 percentage points, this year to 10.77 percent, leaving them down 115 basis points over the past two years. The dollar- denominated warrants have more than tripled in price since the exchange to 13.15 cents as of Jan. 20 and have made five annual payouts worth a total of 11.75 cents, according to data compiled by Bloomberg and Argentina's Economy Ministry. Annual economic growth has averaged 7.1 percent over the past six years.

Morgan Stanley's 90 percent return estimate is for creditors who have held onto the securities since the swap.

Dart and Singer's funds, which also turned down a second exchange offer in 2010, are seeking to enforce several judgments they've won in U.S. courts. The Supreme Court is considering whether to hear an appeal from the funds related to their attempts to seize $100 million in Argentine central bank assets being held at the Federal Reserve Bank in New York. A federal appeals court said that money is shielded under the U.S. Foreign Sovereign Immunities Act.

'Whatever It Takes'

Argentina expects the U.S. will support its position in the case, said an official at the country's central bank who declined to be identified because he isn't authorized to speak publicly. The government says that so-called vulture investors holding about $4 billion of debt are pursuing litigation against the country.

Officials at Elliott declined to comment.

"We're glad to see the Supreme Court is seriously considering hearing the appeal," said John Missing, a lawyer for Dart's EM at Debevoise & Plimpton in London. "It's important that the courts get this right especially given the welter of potential sovereign defaults that are hanging out there. We're prepared to go the distance, to do whatever it takes to get what we're entitled to on these bonds."

The U.S. Department of Justice declined to comment on the appeal, said spokesman Charles Miller.

Past-Due Interest

The hedge funds are pursuing an "expensive strategy," yet will likely profit if they recover past-due interest and interest on interest in addition to principal, said Siobhan Morden, the head of Latin America strategy at RBS Securities Inc. in Stamford, Connecticut.

"The value of their claim is going to become increasingly dependent on interest in arrears as opposed to the recovery of principal," Morden said. "There's an inflection point at which you will reach break-even in terms of accruing interest."

President Cristina Fernandez de Kirchner, who began her second term in December, four years after succeeding her husband, said in 2010 that the second restructuring offer was the final chance for holdout creditors to get new bonds. Argentina hasn't sold bonds overseas since the default, tapping central bank reserves instead to make debt payments.

'Opportunity Cost'

The cost of protecting Argentine debt against non-payment for five years with credit-default swaps fell 112 basis points last week to 789, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

The peso fell 0.1 percent to 4.3245 per dollar at 10:06 a.m. in Buenos Aires.

The extra yield investors demand to hold Argentine government dollar bonds instead of U.S. Treasuries fell 36 basis points to 785, according to JPMorgan Chase & Co.'s EMBI Global Index. The yield spread has declined from 925 basis points at the end of last year.

"Argentina has been one of the strong performers during the past five years in emerging markets," said Vitali Meschoulam, head of Latin America strategy at Morgan Stanley in New York. "Obviously there is an opportunity cost of these guys not having participated in the 2005 exchange."

These hedge fund managers were unwise not to accept the offer in Argentina. And hedge funds refusing to accept the offer in Greece will suffer a similar fate. Contrary to what Reuters reports, hedge funds holding Greek bonds that mature in March do not have the strongest hand in the critical negotiations. They will be taught a lesson.

Of course, all this is trivial to Yanis Varoufakis, Professor of Economics at the University of Athens. Below, he tells BBC any deal will be "unsustainable" and "forgotten in the annals of history". Varoufakis is hopelessly cynical and he will be proven wrong.