Haircut Negotiations: Hedge Funds Bet on Profits from Greek Debt Talks

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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.