In an article published on November 4 entitled "Heads We Win, Tails You Lose: Hedge Funds Love Greek Bonds," I lamented the fact that over the course of the nine or so months since the Greek bond swap, some prominent hedge funds have touted Greek government debt (GGBs) as a "wonderful opportunity":
Greek bonds are being disingenuously pitched as some kind of wonderful value -- the investment opportunity of a lifetime. This is about as far away from the truth as one could possibly get. GGBs are the very definition of a risky bet and it appears that the worst case scenario is indeed the most likely: Greece will be cut off from aid and every creditor will end up taking further writedowns.
This appeared to be a fairly straight forward thesis. Greece cannot meet the IMF mandated target of 120% debt-to-GDP by 2020 unless someone writes down a portion of their Greek debt. The idea wasn't that the group most likely to take a haircut was private creditors -- as the hedge funds rightly point out, thanks to the bond swap the bulk of Greek debt is now concentrated in the public sector thus making a new private sector impairment largely ineffectual in terms of putting an appreciable dent in Greece's debt load.
The idea was instead that given the ECB's refusal to write down its holdings, given Germany's insistence that no haircut be applied to EU governments' Greek debt, and given the IMF's hardline on 120% debt-to-GDP by 2020, the whole endeavor would fail, Greece would exit the euro, and everyone (including the hedge funds) would thereby suffer.
Hedge funds, of course, always have an ace up their sleeve. Tuesday night, eurozone finance ministers met to discuss a set of measures designed to cut Greece's debt to 121% of GDP by 2020. One of the proposed mechanisms involved cutting the interest rate premium on loans extended to Greece from 150 basis points to a paltry 25 basis points.
German finance minister Wolfgang Schaeuble objected, reminding his fellow ministers that if these terms were accepted, the KfW Development bank (which is owned by the German government) would be paying a higher rate to borrow than Greece, a decidedly ridiculous scenario given that KfW extended the loans.
Apparently, this impasse led the ministers to consider a Plan B of sorts (here's where the hedge funds come in). From the Financial Times:
An alternative proposal involves offering 10 billion euros of...loans to Athens from the [EFSF which] would support a more ambitious scheme to purchase Greek bonds held by private investors.
Many of these "private investors" are undoubtedly the hedge funds mentioned in my previous article (cited above). According to ZeroHedge, the rumored price to be paid for these bonds is 25 to 50 cents on the dollar which, depending on the entry point, will likely mean hefty profits for some of the funds who got into the debt below 20 cents -- think Third Point, Appaloosa Management, and Fir Tree Partners. Consider that this effectively represents eurozone taxpayers paying for hedge funds to make huge profits.
While this proposed transaction will result in very real gains for the hedge funds, the eurozone itself will likely see nothing in return. This proposal is part of a broader effort to wrangle Greece's debt-to-GDP ratio under 120% by 2020. In other words, all of this is part of an attempt to put Athens on a sustainable path so everyone in the euro can stop throwing money into a black hole.
But this 10 billion euros will suffer the same fate as every other n-billion euros thrown at the Greek debt problem: it will disappear and will fail to make a dent in Greece's debt burden. Why? It is simply a matter of something most 7th grade math students understand -- fractions. From ZeroHedge:
[The 120% debt-to-GDP] number...has virtually no chance of being hit when one accounts for the denominator: the collapsing Greek GDP which last quarter tumbled at a 7% rate.
The moral here is this: thanks to the periphery's unfathomable willingness to suck Northern Europe dry, Greek debt may indeed be a profitable trade. However, once everyone in Germany and the other AAA countries realizes that the EFSF just paid several prominent hedge funds a nice Christmas bonus, the whole enterprise will accomplish only one thing: it will further prejudice EU creditor countries against future bailouts, leading to more instability and a more fractious political environment going into 2013. Remain short European equities (FEZ) and the euro (FXE) as the Greek drama unfolds.