The Hidden Risk On A Hedged Position

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Includes: SPY
by: Jason Farkas

“If Private Santiago was to be transferred off the base, then why would he be in danger ... Why the two orders?”

-- Lt. Daniel Kaffee, "A Few Good Men "

Jefferies & Co, Inc. just announced that they have reduced their holdings of European sovereign debt by $2.2 billion. But just last week -- and for months prior – many holders of European debt declared themselves to be “hedged” against any risks via credit default swaps (CDS).

Yet if Jefferies were hedged, then why would it need to reduce the position? In other words, why "the two orders?" You’re either hedged, or you’re not.

Here's what might be happening: Sovereign bond hedgers may be realizing they are much more at-risk now than they were previously. Why?

It's probably a result of last week's “voluntary” Greek bond haircut -- i.e., a reduction in how much the Greek bondholders will be paid back. The International Swaps Dealer Association (ISDA) declared the 50% haircut "voluntary," thereby technically making it a "non-default."

See, if Greece couldn't pay back 100% of the borrowed money, that would be an honest-to-goodness default. But because Greek debt bondholders (with much arm-twisting by the EU, ECB and IMF) agreed to accept 50 cents on the dollar before Greece formally said it's broke, it's a voluntary haircut. No "default" language around here, please!

But if the Greek haircut is “voluntary,” then any haircut for any other sovereign debt could be ruled a non-default, too. And since CDSs only protect the hedgers in case of bond defaults, this ISDA decision has effectively rendered the sovereign CDS market useless on at least the first 50% of losses.

Why should you care? Here's why.

Let’s say -- hypothetically, of course -- that many European banks hold sovereign bonds from Portugal and Italy. Prior to the “voluntary” ruling, rather than sell bonds at a loss, banks would buy CDS contracts as protection, so they’d be hedged if the bonds defaulted. But if the ISDA refuses to call haircuts “defaults,” then the CDS hedges stop working as intended. And so, the risk of falling bond prices becomes important again, making the nervous markets even more jittery.

You can see the irony: In an effort to decrease contagion from the Greek haircut, the ISDA, EU, ECB and IMF have unwittingly increased the contagion risk. By refusing to trigger CDSs on Greece, they have shrunken the pool of sovereign debt buyers, who are now less able to hedge their bets, and raised the pool of sovereign debt sellers.

You may wonder if there is an Elliott wave angle in all this. There is. Socionomics postulates that in bear markets, authoritarianism increases. But the authorities rarely make things better, because unintended consequences arise no matter what decision they make.

EWI president Bob Prechter wrote this about credit default swaps in the July 2011 Elliott Wave Theorist*:

“... if a deflationary crash is coming, [credit default swaps] won’t work. CDS issuers will default. There is no way out.”

The world is awash in debt which it can’t possibly repay, but the current power structure around the world has a vested interest in delaying that fact. The crumbling of the sovereign debt and its credit default swaps market fit right in with our view. Hedgers beware!

Disclosure: I am short LYG, C, BBVA, STD.

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