When Is A Hedge No Longer A Hedge?

“Oops, we did it again.”

That is the mantra today of any number of banks, insurance companies, investment firms, and hedge funds.

We hardly qualify as experts on the most sophisticated swaps and derivatives but know just enough to try and explain a complex issue in a somewhat simplistic fashion.

The issue pertains to these 50% “haircuts” you have been reading and hearing about almost nonstop as it pertains to Greek debt, and perhaps ultimately to that of other European nations.

What is happening in the most basic terms is that holders of Greek debt, especially the large international banks, are being politely “forced” to accept write-downs or losses on their Greek debt holdings of 50%.

But behind the scenes, they, and especially aggressive hedge funds, are screaming bloody murder, as they believed their risks on Greece’s debt were well-protected with “credit default swaps” (CDS’s), which act as a form of insurance against a default on debt which cannot be paid off according to schedule.

We attended a Bloomberg conference last night and this was a hot topic of discussion, along with many other issues, most prominently the ongoing threat of European recession, no matter what “rescue plan” was arrived at.

But back to the CDS issue. In effect, many institutions would likely have been happier with what is called a technical default in Greece, as they then would have been able to collect something in the area of an 80-90% of the face value of the debt, instead of the “forced” 50%. (Again, this is very simplistic).

Shades of the mortgage crisis in the U.S. all over again in many ways, where large institutions vowed they would never again be placed in a situation where overexposure or misplaced exposure to the derivatives market could lead to large unanticipated losses.

In this case, they are claiming that the European government bodies are “changing the rules in midstream”.

“It punishes the banks that were well-hedged and managed, and I think it's just starting to sink in as to what this might mean,” said Peter Tchir, the founder of hedge fund TF Market Advisors in New York. “Bank hedging desks are definitely now trying to re-evaluate their use of default swaps”.

“It is symptomatic of the regulatory and legal goalposts being constantly shifted either randomly or to suit political interests,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London. “For genuine long-term investors, it's a major liability.”

The even bigger issue however is the lack of transparency and regulation in the CDS market. There have been many calls for CDS’s to in effect trade in an exchange-like fashion with full discovery by any market participant. This has never truly happened and another major hurdle in the current European “rescue deal” is figuring out who owns what debt, which CDS’s, and who the counterparties in all the deals truly are.

Good Trading!
David W. (aka The Underground Trader)

 

David W’s FlashTrading Service Is Now Live! The service is unique in its approach to trading options: low capital at risk, frequent market commentary based on the futures markets and real-time options trading, not to mention the options insights you can't help but pick up! Try It Today

 

Remember, you are in control your email alerts! You can receive alerts for more than 25 free research report alerts including: The “10.0” Report, The Insiders Report, ETF Leaders Report, and The Focus List.