Saturday, January 21, 2012

What drives hedge funds which buy Greek debt?

As Greece prepares a legislation to force all private bondholders to take losses on its debts as part of an ECB-EU-IMF rescue package, the hedge funds appear to be playing a game of brinkmanship with Greece.

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in a human rights court to make good on its bond payments. The novel approach would have the funds arguing in the European Court of Human Rights that Greece had violated bondholder rights, though that could be a multiyear project with no guarantee of a payoff.

One of the terms of the 130 billion euro ($165.5 billion) rescue package for Greece, is to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange. In addition, the Greek government is unwilling to offer the 4% interest rate on new bonds received in exchange for the old bonds. Hedge funds argue that this will effectively increase the relative haircut to between 60-70%.

Though Greece has been negotiating with its bond holders on voluntary haircuts, in the range of 50% of the debt value, these talks have made little headway. The EU-ECB-IMF had made such haircuts and consequent debt restructuring a mandatory requirement for releasing the next instalment of rescue package funds for Greece.

Many of the bondholders - hedge funds, pension funds, banks, etc - have already insured their positions through credit default swaps and find the deal offered by Greece less attractive than a forced default. But a forced haircut would unnerve the markets and potentially destabilize the global financial markets.

Interestingly, over the past year, despite there being ample evidence of Greece being close to default, several hedge funds have continued to buy into Greek debt. All of them were ttracted by the massive potential returns despite the potential for default and a perceived belief that EU and ECB would let Greece default. A Times report nicely captured the incentives,

"Greece may never be able to pay off its huge debts, but its bonds, long scorned by investors, are suddenly being gobbled up by hedge funds... many have turned their attention to the hot yet risky euro zone trade of the moment: buying Greek government bonds that traders say are changing hands for as little as 36 cents for each euro of face value. The investors hope to book a fat profit on the expectation that the European Union and the International Monetary Fund will once again bail out Greece, fearing a global financial disaster if they do not...

Those speculating in Greek bonds are taking on well-documented risks, not the least of which is the possibility that the country will fail to reach a final agreement with the I.M.F. and the European Union and will not get the next portion of money needed to avoid default."

In fact, a major portion of the current bond holders are not the original ones - large European banks - and are speculative investors who have purchased their bonds in recent months. The Times report estimated that as on September 2011, about 30% of the investors bought their bonds after July 21. This share would surely have climbed in the subsequent months.

I have two observations from these events.

1. The hedge fund managers are obviously playing chicken with Greece and Eurozone. Who will be the first to blink? If they are able to scare Greece, EU, ECB, and the IMF away from forced default and/or to get the IMF and EFSF/EU to accept losses, by amplifying fears of a global financial market contagion (driven by bond market vigilantes), then the hedge funds stand to make fantastic gains. Conversely, the governments could call the bond market bluff and proceed with the haircuts and debt restructuring, thereby imposing serious costs on the hedge funds.

2. The action of the hedge funds in buying into Greek debt despite clear knowledge of all the associated risks bears remarkable similarity to the role of real estate agents in India who scout for lands emrboiled in litigation or whose titles are not clear.

Such lands, embrolied in litigation or uncertainty for many years, even decades, cannot be developed without settling the encumberances by clearing the title. Real estate agents with close political connections see them as opportunities. They buy into these lands, including the litigation, at cheaper than the market rates. Then they use their official connections to either weaken government claim (for example, by making the government advocates soft-peddle on court litigation) and eventually get it transferred to private interests or use political muscle power to arm-twist the other private parties into signing away their interests at a bargain rate.

Such agents, who are present in all Indian cities, and have connections with influential people in the establishment - politicians, officials, and judges - are classic risk managers. They spot the opportunity, weigh pros and cons - risks associated with getting the title cleared off encumberances - and make their investments.

The modus operandi is eerily similar to that of the hedge fund managers who have invested in Greek debt despite enough evidence that Greece would default on its sovereign obligations. Like the real estate agents, all these hedge fund managers wield considerable influence in the corridors of power - governments, central banks, financial market regulators, and big financial institutions. Again, like them, the real estate agents try to leverage this influence to benefit them. In fact, they become confident that with an appropriate mixture of brinkmanship and nudging of the powers-that-be who decide on the terms of the Greek default, they would be able succeed with a favorable debt restructuring deal.

These real estate agents operate purely outside the legal boundaries. However, the trades executed by hedge funds, in the face of very obvious and extreme risks, are perfectly legal. Is there a case for atleast some regulation on such trades?

In the instant case, it was plain obvious, as early as early last year, that haircuts on Greek debt was inevitable. In the circumstances, the only logical reason for hedge funds to pile into Greek bond was a belief that they could influence the debt restructuring process. Given the moral hazard and other incentive distortions created by these actions, is there a case to restrict such trades, especially under such conditions?

Supporters of these trades will obviously point to their positive role in risk diversification by helping banks off-load risks to those best able to bear them. But then this diversification becomes a double-edged sword when the buyers do so on the aforementioned assumptions. Systemic risk then gets amplified instead of being diversified.

Post script - As for Greece itself, even with the deal, its debt would be no less than 120% of GDP in 2020 (down from 140% of GDP at $450 bn today) — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

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