Traders' Targets: Portugal And Spain

As fears of financial "contagion" resurface in Europe on the back of Ireland's woes, hedge-fund managers are cautiously setting their sights on potential problems in countries such as Portugal and Spain. But they face political and other challenges in placing bearish bets.
The deteriorating economic picture in some corners of Europe clearly has the attention of many hedge-fund managers and other investors who see Ireland's rescue package as little more than a bandage for the continent's woes. They are expecting more bad news to come, predicting that borrowing costs elsewhere will become prohibitive, potentially forcing other countries to also seek a bailout or restructure their debt.

Yet some hedge-fund managers aren't piling wholesale into bearish bets on weak European countries for a variety of practical and political reasons.
One is basic: Predicting if or when a government may request a bailout can be difficult, a problem that is compounded by the time and expense that comes with placing and exiting trades around European sovereign and corporate debt.

Also, the notion of betting against Europe's peripheral economies has also become an emotional topic amid debate about whether such moves have contributed to those countries financial woes, rather than merely reflecting them.
Politicians and regulators in some European countries and the U.S. have called for the banning of certain instruments, such as derivatives known as credit-default swaps. For their part, hedge-fund managers are quick to argue that bearish bets are a result of the economic problems, not the cause, and that much of the negative pressure comes from traditional asset managers, banks and corporate treasurers, seeking to protect themselves.

Nevertheless, some managers are concerned that politicians could move to ban CDS and say they are limiting their exposure to them.
The Irish rescue effort comes on the heels of Greece's acceptance in May of its own international bailout to avoid default. Many hedge-fund managers and investors now see Portugal, with its combination of budget deficits, high government debt and low growth, as the next shoe to drop.
But, investors say, the bigger concern is if funding problems spread to much bigger economies, such as Spain, Italy or even France, where investors fear a bailout would be impractical. The worry, therefore, is that it could lead to a restructuring of debt that would inflict losses on bondholders, many of which are European banks.
Among those examining Spain is George Papamarkakis, at hedge fund North Asset Management LLP, which has long been focused on sovereign issues in Europe. In recent weeks, the roughly $200 million London-based fund has been adding to bearish bets on Spanish government bonds and the local equity-market index, according to Mr. Papamarkakis, who says he isn't using CDS for his Spanish sovereign trade.
With Spain's fundamentals weak, Mr. Papamarkakis says he expects the domestic economy to continue to suffer. And, as the country's cost of borrowing increases, it will become more costly for Spanish banks to borrow money, and therefore other local companies as well. The trade is among the fund's top three positions.

"The elephant in the room is that the [Spanish] real-estate market continues to be over-levered and hasn't corrected," says Mr. Papamarkakis. Such a correction would have an impact on local asset prices and in turn on the local equity markets, he says.
Fortelus Capital Management LLP, a credit and distressed fund with more than $1 billion in assets, also is betting on the increasing likelihood of default in European countries. In recent weeks, it has added to existing bearish bets on the debt and equity of financial, construction, real-estate and industrial companies in Southern Europe, according to a person familiar with the matter. Its strategy includes short positions in CDS and the bonds directly.

Fortelus's view is that the rising cost of borrowing for countries will make it more expensive for banks and other companies to find funding too. The trades account for the largest "short" position for the London-based fund, which typically has more bullish than bearish bets. And, the fund has been shifting its focus in terms of countries as concerns have spread from Ireland to Portugal and Spain, and now to Italy and even France, the person says.

Still, events are proving difficult for hedge funds to predict. Some managers at macro funds, which focus on economic trends in currencies, interest rates and other instruments around the world, were caught out by the euro's sudden downturn earlier this month linked to Ireland's woes. Many managers had been buying the currency during September and October as part of a trade betting that the dollar would weaken on the back of the U.S.'s latest round of quantitative easing.

As a result, some funds have reduced their positions as part of a broader move to take risk off of the table heading into the end of the year, where trading tends to be lighter due to the holiday season.
Still, "the problems in the euro zone are not going to go away just because Ireland has been bailed out," says Christopher Peel, founding partner of London-based BlackSquare Capital LLP, which invests in hedge funds on behalf of clients. "Other countries whose houses are not in order are going to be held to the same scrutiny. I don't think those issues are going to go away, which is why the euro is going to stay under pressure."

WSJ - 27.11.10