The Greek Default And How To Play It

Includes: BNPQF, DB, EPV, EUO, GS, MS, VXX
by: Ramy Saadeh

The last couple of weeks, while not crisis-free, markets turned their lights away from Greece only to shadow other EU disruptions paving the path of the Galilee. Now, the lights are back to Greece and the country needs loans so that it can refinance its debt Everest. Unfortunately, Greece will not get a single euro until it irons out the details of private sector involvement and how much the holders of Greek bonds are willing to lose. Moreover, even if a deal is reached, many obstacles still stand in the way of the debt swap. Hedge funds have threatened to sue if they are forced to take unwanted haircuts, particularly if the swap does not provoke a credit event.

Greece needs to seal the agreement in time to meet a debt repayment of €14.5B ($18.5B) in March as the EU and IMF have warned that they will not consider Athens' debt to be back on a sustainable track and will not release further aid without the PSI deal. So this time, if an agreement is not reached, the troika will stop kicking the can and Greece will default!

First stories on Friday were that the Greek government and private creditors have reached an initial agreement for a voluntary swap of Greek debt whereas they agreed that new bonds will replace existing Greek debt for 30-year maturity and carry a coupon that could reach 3.9% and go as high as 4.75%. However, later on, CNBC reported that a deal on the terms of a debt swap between private Greek bondholders and the Greek government has not yet been reached.

It seems that a Greek default is imminent, many seem to agree:

  • Moritz Kraemer, the head of S&P's European sovereign ratings unit said "Greece will default very shortly. Whether there will be a solution at the end of the current rocky negotiations I cannot say."
  • Edward Parker, managing director for Fitch's Sovereign and Supranational Group in Europe, the Middle East and Africa said "It is going to happen. Greece is insolvent, so it will default." He added "It clearly is a default however they try to spin it."
  • Paul Rawkins, Fitch's lead analyst for Greece, assumed "It would be a default regardless of the size of the NPV loss."

Why is a default imminent?

1) Even if a deal was reached, there will still be legal and logistical obstacles.

2) Greece will not become solvent overnight. This chart from Nomura Global Economics shows it all:

(Click to enlarge)

3) The ISDA has not yet given a clear statement if such a deal will be considered as a credit event causing CDS to be paid out.

4) If agreement was ruled as a no-credit event, hedge funds might take it to Greek courts, holding up the debt swap ad infinitum.

I would like to point that if CDS is not paid, this will even be a far worse scenario that having the CDS paid. The reason is that market participants, who have bought Greek CDS to avoid a default (A haircut of 1% is considered a default for any CDS holder) will expect a compensation for their losses, and without this payment, the CDS market will have no purpose, it will collapse. If market participants had no guarantees against their sovereign holdings, not only they will dump their CDSs but the sovereign bonds they held these CDS against. Remember, Greece is just the current can on the road but other cans are still on the road, we'll have to deal with Portugal, Italy and Spain.

Pimco's Mohamed El-Erian told CNBC, "This problem is not going to go away. It's going to weigh on markets here and we're going to see the same set of headlines over and over again. We simply cannot continue to kick the can down the road, because we're coming to the end of the road in Greece."

And with the end of the road, come the default.

How to Profit from a Greek default?

The end of the road will inevitably create extreme volatility in the markets especially that the size of the current default is more leverage than the size of the Lehman collapse. It will offer investors great potential for profits, conditioned they are on the right side of the trade. The volatility index which has dropped significantly over the previous weeks closing at 18.26 on Friday reached 19.87% on the RSI (a signal most technical analyst consider a signal to buy); the VXX (iPath S&P 500 VIX Short Term) offers an exposure for an increasing volatility, noting that the volatility index touched the 70 level during the Lehman crisis.

Investors that feel that European Banks and companies will be affected might want to consider ETFs such as the Lyxor ETF STOXX Europe 600 Banks Daily Short (1X↓) LYQ9:GR, or the ProShares UltraShort MSCI Europe Index Fund (2X↓) EPV, or the ETFX Dow Jones EURO STOXX 50 Double Short ETF (2X↓) SEU2:LN.

Noting that Germany's exposure to the Greek debt is 19%, those who think the DAX could possibly take a hit should look to ETFX DAX 2X Short ETF (2X↓) DES2:LN, while those who think that France's exposure of 32% could bring more damage should consider the Lyxor ETF XBear CAC 40 (2X↓) BX4:FP. And since Italy stands next in line to take the hit, not to mention it's exposure to Greece, the Lyxor ETF XBear FTSE MIB (2X↓) XBRMIB:IM is the best way to short Italy.

For those who think that the euro will drop after a Greek default long the ProShares UltraShort Euro EUO.

Additionally, the total exposure of banks in the United States is higher than German banks. US banks' total exposure of Greek debt amounted to around US$41 billion. But the nature of exposure US banks have is rather different, it is through guarantees or CDS. It shows that there could be potential problems for US banks [Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS)] if CDS were triggered and obviously problems for European banks [BNP Paribas (OTCQX:BNPQF) Deutsche Bank (NYSE:DB)] if bonds default.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.