Betting on the eurozone’s weakest links

Posted by Gwen Robinson on Dec 10 10:00.

One man’s woe is another man’s windfall, as the financial crisis reminds us again and again.
Now, the eurozone’s problems are providing a field day for some savvy hedge funds who just can’t wait for more trouble to rear its ugly head. And their prayers are likely to be answered.
As the FT reports on Thursday, Greece’s snowballing problems come amid signs of growing weakness in parts of the eurozone, including on Wednesday, S&P’s move to revise Spain’s ratings outlook to “negative” and Ireland’s announcement of its harshest budget in decades.
All that before we even move further east, to another range of problems festering on the EU’s doorstep.
But back to the — err, “good” news.
As the Wall Street Journal notes on Thursday, the sudden spotlight on troubled government borrowers is presenting a “long-awaited payday for investors who placed early bets against countries now under pressure”.
Generally, these “meltdown” investors have focused on countries considered the weaker members of the eurozone: Portugal, Italy, Ireland, Greece and Spain - collectively known in some circles (though definitely not their own) as the “PIIGS.”
Some have bet that bond prices of specific countries would fall, or that stocks and currencies would suffer in the wake of debt worries. Others have spent the last year buying up credit-default swaps on debt issued by such governments.
And what do you know, European credit spreads have continued to widen this week, as sovereigns take yet more punishment. As Markit’s Gavan Nolan reported on FT Alphaville on Wednesday, the pressure on Greece, in particular, hasn’t let up.
On Wednesday, its CDS spreads were as wide as 240bp at one point, nearly 30bp wider than Tuesday’s close, following Fitch’s downgrade and the declaration by the Greek finance minister that “we are not another Iceland and we are not another Dubai”. As Nolan concluded: “The government declared that they would do whatever it takes to reduce the budget deficit but the markets are clearly unconvinced”.
So, rather than cashing in on their undoubtedly already-handsome profits, some of these “bad-news” investors say they are expanding their wagers, convinced that the sovereign debt of a number of countries will run into more problems over the next year or so.
From the WSJ (our emphasis):Investors including Balestra Capital, Hayman Capital Partners, North Asset Management and Pivot Capital Management have been anticipating such flare-ups for at a year or longer, betting that some countries would emerge from the financial crisis in much worse shape than others.
Those bearish positions had led to a difficult 2009, as investor confidence picked up and rivals gained by buying risky investments. Kyle Bass’s $650m Hayman Capital suffered losses this year, for example, while James Melcher’s Balestra Capital is up about 5% in 2009, according to investors, less than the 20% or so gain of the average hedge fund.
But a chorus of warnings this week about the hazards of government borrowing from Dubai to Greece and the UK has rattled markets around the globe — and some of those early bets are starting to pay off. On Wednesday, Standard & Poor’s Ratings Services changed its outlook on Spain’s credit rating to negative, a sign that a downgrade could lie ahead. A day earlier, Fitch Ratings cut Greece’s credit rating to the lowest in the 16-member euro zone. On Monday, S&P cut Portugal’s outlook to negative.
Hayman - for one - said the last few days have been the firm’s “best this year”, adds the Journal, noting that the $1bn firm began buying CDS on Greece, Ireland and Portugal two years ago and quoting one Balestra executive saying: “It started with Dubai and now problems with Greece and other hot spots, like Latvia and Eastern Europe”.
The next big concern, as Der Spiegel’s Wolfgang Reuter points out in a recent article, is the impact of all this on the euro.
The German journal quotes Josef Ackermann, Deutsche Bank chief, at a recent Berlin economic gathering, warning that “a few time bombs” are ticking in the eurozone - namely, the problems of some highly-leveraged, smaller EU member countries - particularly Greece.
The real fear highlighted by Ackermann, says Reuter, is that of a national bankruptcy in the eurozone, and the question as to whether such a bankruptcy “could destroy the common European currency”.
Reuters continues (our emphasis):Greece was always at the very top of the list of countries at risk. But now the danger appears to be more acute than ever… [it] has already accumulated a mountain of debt that will be difficult if not impossible to pay off… and if investors lose confidence in the bonds, a meltdown could happen as early as next year.
That’s when the government borrowers in Athens will be required to refinance €25 billion worth of debt — that is, repay what they owe using funds borrowed from the financial markets. But if no buyers can be found for its securities, Greece will have no choice but to declare insolvency — just as Mexico, Ecuador, Russia and Argentina have done in past decades.
This puts Brussels in a predicament. EU rules preclude the 27-member bloc from lending money to member states to plug holes in their budgets or bridge deficits. And even if there were a way to circumvent this prohibition, the consequences could be disastrous. The lack of concern over budget discipline in countries like Spain, Italy and Ireland would spread like wildfire across the entire continent. The message would be clear: Why save, if others will eventually foot the bill?
On the other hand, argues Reuter, if Brussels left the Greeks to their own devices, “the consequences would also be dire”. Furthermore, there is a threat of a domino effect, he adds.
The big question, in Reuter’s view, is: Can a Greek bankruptcy even be prevented anymore? He continues:The answer, at least initially, depends heavily on the ECB. Will the custodian of the euro continue to accept Greek bonds as collateral for short-term liquidity assistance, or will it turn down the securities in the future? Another possibility is a compromise, under which the banks would pay additional interest when they submit Greek bonds.
The next meeting of the ECB takes place on Dec. 17…Central bankers in the eurozone are already speculating, behind closed doors, what would happen if the Greeks started printing euros without ECB approval. There is no answer to the question, and that makes central bankers from Lisbon to Dublin even more nervous than they are already.
Lex, however, thinks Greece - and other weak links such as Greece, Portugal and Spain that have “refused to grasp their deficit problems by the horns”, should look to Ireland’s swingeing cost cutting measures as an example.
From Thursday’s note:The government may get gored in the process, but Dublin is at least trying to obey the eurozone rules.

Related links:An ugly December for the euro so far - Reformed Broker
The return of widening sovereign credit spreads - FT Alphaville
There goes the δομημένη χρηματοδότηση… FT Alphaville
S&P revises Spain’s outlook to negative - FT Alphaville