Bearish Bets On Greece: Short-Lived?

The short bet against Greece mightn't be around for long. The increasing possibility that European nations will come to the rescue of Greece is upending what had been a highly successful trade—betting that Greece would struggle or be unable to pay off its debt. The two main winning bets were buying credit default swaps, which rise as the risk of default increases, and shorting Greek bonds, which fall in value when the borrower is in trouble. In both cases, investors made big profits in recent months.

Now, with a bailout plan for Greece emerging, some investors are moving out of those now money-losing trades. A key factor hurting these trades is that if a plan goes through, there would be little doubt Greece could pay off the bonds it has issued that mature in April and May. On Monday, the annual cost of insuring €10 million of Greek government debt for five years was €341,000, down 14% from last Thursday. The cost hit a peak of €425,000 on Feb. 4.


"You've already had a scramble to close out the short positions," said Gary Jenkins, head of fixed-income research at Evolution Securities in London. Because investors are less worried about Greece, one of the trades that put pressure on Greek bonds has been scaled back. In that trade, investors bought credit insurance on Greece from big banks, which serve as market makers in cash and derivative trades. The banks were effectively betting in favor of Greece, so to hedge themselves they would sell short Greek bonds, which means they sold bonds hoping to buy them in the future at a lower price.
But less demand for credit protection means that banks have fewer reasons to short the cash bonds, which means fewer Greek bonds are being dumped on the market.

A dreaded short squeeze could hit investors. That happens when the price of a security rises, forcing investors who are short the security to cover their positions to cap the losses. A shortage of securities can make it more expensive to cover the bet, forcing investors scrambling to get their hands on the security to bid up its price.  Investors weren't worried about being squeezed because Greece needed to sell some €23 billion of debt by spring. That huge supply of debt meant that investors had plenty of bonds to buy if they needed to cover short bets.

But a bailout of Greece could mean the country won't have to issue as much debt to the bond markets. A good portion of what is issued could be bought by state-backed entities. That would cut down on the debt investors needed to cover the short trade. Another squeeze could come for investors who shorted short-term Greek debt maturing in one and two years. If investors believe that the risk of Greek default is over, that sentiment would lead to buying and a rally in the value of the bonds. That, in turn, would make it more expensive to cover short positions.

European officials, meanwhile, have unnerved some investors in recent days with calls for tighter regulation of the sovereign credit-default-swap markets.German market regulator BaFin is preparing a report for Germany's Finance Ministry on speculation in Greek debt, an agency spokesman said Monday. BaFin analysts are searching public trading data for signs of speculation in the trading of Greek credit default swaps.

"It is important to know if speculators are betting against Greek national debt," said BaFin spokesman Ben Fischer.Given the cross-border nature of such trading, many politicians believe any regulation would have to be global in scope to be effective. Germany has been pushing other major economic powers, including the U.S., to endorse a regulatory framework for sovereign CDS trading.
Berlin already has the support of most European countries. French Finance Minister Christine Lagarde said in a Sunday radio interview that the derivatives should be "at least very rigorously regulated" or even "forbidden." Luxembourg Prime Minister Jean-Claude Juncker, in a German newspaper interview on Monday, said the EU has the necessary "torture instruments" to deal with speculators and is prepared to make use of them.

The fear of regulatory intervention also may be sparking a decrease in the price of the credit insurance. Hedge funds might have bought protection against Greek default in what would be a short position. Now, to avoid detection by regulators, hedge funds are selling credit insurance to cancel out the short position, a London banker said. To be sure, a bailout of Greece could end up a short-term solution. Within months, the country could end up struggling to cover its maturing debt.

"I don't think it's going to be the catalyst people are hoping for," said George Papamarkakis at North Asset Management LLP. The London hedge fund, which manages about $300 million in assets, was among investors that bought Greek bonds during a January sale. Mr. Papamarkakis described the fund's position in Greek bonds as "modest."  Mr. Papamarkakis is expecting the Germans to bail out Greece, and bond spreads will likely narrow once a specific plan is announced. Still, the plan is "not going to have as big as impact as some are hoping for," he said, because many investors already have factored in a bailout.
Mr. Papamarkakis believes shorter-term bonds currently are "more attractive" than longer-term bonds because he doesn't see the likelihood of default over the next year or two. "At these price levels, especially the front-end bonds-the two-year-are cheap if there is some kind of support package."

For Mr. Papamarkakis to buy them, he would want to see very few conditions on Greece in terms of the measures it would need to take in exchange for the financial support. He thinks that is unlikely, expecting the deal to be "very onerous." If there was a bailout that included some kind of European-level guarantee, such as in the form of insurance of being offered European bonds in the event that Greece defaults, "that would be exceptionally reassuring," Mr. Papamarkakis said. But he thought that was unlikely.
He says there is still a lot of uncertainty for investors in terms of what form a bailout might take. "We don't have a good enough understanding of it," he said.

WSJ - 02/03/2010