Friday, January 13, 2012

Gaming the system for personal gain but international pain

I am a free market kind of guy, but games that threaten the global financial system worry the heck out of me. I am not suggesting more regulation; I am publishing this to highlight some risks that are baked right into the Euro-cookie.

Everyone knows that Greece is in trouble financially. In many ways, the Greeks no longer rule their own country; a troika unelected by any Greek is in charge. The International Monetary Fund, the European Commission and the European Central Bank now hold the purse strings for the birthplace of democracy. Greece is not alone, of course, it just happens to be in the news. Italy's situation is similar.

Any rational investor would want to protect his capital during difficult times. You know, maybe buy some insurance (a credit default swap, or CDS). Naturally, every insurance policy has its fine print. Credit default swaps only pay off under certain forms of financial failure. You are insured only for certain hazards.

Here is where the cookie starts to crumble. According to the Institute for Individual Investors, there is a total of approximately €355 billion in outstanding Greek debt, with €100-140 billion held by the ECB, IMF, and EU (the Troika). This includes the €35-40 billion purchased by the ECB during 2011. The remaining €200 billion plus is held by banks, pension funds, and, increasingly, hedge funds. It all comes to a head in the next few weeks.

Those private holders are expected to take a €100 billion and change loss; the Troika’s holdings would be unaffected by the plans to resolve the debt crisis. That alone should raise eyebrows, but let's look more closely.

If certain Greek debt was expected to take a 50% write-down, it would be priced at 50% of face value. Instead, it is selling at a bit over 30% of face value. What gives? Let's quote directly from the IFII's free subscription Tycoon Report for January 13th:

...magnanimous private holders are expected to voluntarily take a 50% haircut. The plan under consideration is that for each €100 of debt tendered, €15 in cash would be received and €35 in long dated (as much as 30 or 40 years), low-interest Greek debt.

Now if this plan was anywhere close to a reality, Greek debt would be trading near that 50% of face value mark, but it is not. It is trading around 32% of face value.

Additionally, if this voluntary plan goes into effect, it would not be a “credit event”. It is a non-event according to the determiner of such things (the International Swaps and Derivatives Association), because it is “voluntary” and not everyone is affected; remember the Troika would be exempt. That is important, because it would not trigger the insurance contracts on the bonds, known as credit default swaps (CDS). Without the insurance to make up the 50% of value that goes poof, losses will be very real.

However, if not enough private holders volunteer, then the deal falls apart and Greece will default for real. The CDS holders will be made whole because a default is a “credit event” and will affect everyone.

So hedge funds have been accumulating Greek debt with the specific intention of not volunteering their holdings. They are also buying CDS, which cost 8% of face value.

In other words, funds are paying €32 for Greek bonds that have a face value of €100, and paying €8 for insurance, resulting in a total cost of €40. When they withhold their bonds from the voluntary swap, Greece will be unable to roll its debt and will default. Then the CDS will trigger and they will receive €100 on an average investment of little more than €40. A tidy 150% profit before the end of March!
I bolded the part that is the most dangerous part of the game. The report goes on to say:
A Greek default will have huge ripple effects. It doesn’t even matter if Greece is forced to leave the Euro or it is allowed to stay -- a run on Italian and Spanish sovereign debt is sure to follow.

The big money manipulation of the markets is going to cause a serious monetary and economic dislocation that could move Europe rapidly from mild recession to full on depression. The US stock market and economy are not on an insulated island; there will be a deleterious effect on both when the tsunami effect hits these shores.
So let's sum this up in layman's language.
  1. Greece owes money it won't pay back, to banks and countries that should never have lent it in the first place.
  2. Those banks and countries have replaced Greece's leadership to try to make sure they get their money back.
  3. Some private parties are buying the parts of the debt that are not controlled by the troika of replacement leaders.
  4. The private parties will try to arrange things to maximize their profit on the questionable debt.
  5. The way they are going about this threatens the global financial system.
Got gold? Cash? This could turn out badly.

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