(BN) Einhorn Trades Swaps for Shorts When Betting on Sovereign Debt

The ECB has had a focus on stopping the CDS market from working.  They have looked at Naked CDS bans.  They have floated rumors about selling CDS.  They worked hard to avoid triggering CDS on Greece.

The EU has always been against short selling.  They like to ban short selling on stocks.

For whatever reason, they have left bond shorts alone for the most part.  Is LTRO and its emphasis on sovereign debt, a way to control the borrow on these bonds?  Is the ECB trying to control bonds so they can’t be borrowed?

If a bank holds the bonds, they may lend them to a hedge fund to short.  Some trading revenue and reverse repo revenue for the bank.

Is LTRO a way to have the ECB in control of ever more bonds in an attempt to make it more difficult to short bonds?  It would push shorts out the curve where they have to take more risk if somehow Europe fixes itself.

In the end the bond market is so big, this program is likely to be relatively small, and most shorts prefer to be out the curve in the first place, but another thing to be wary of when shorting.

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Einhorn Trades Swaps for Shorts When Betting on Sovereign Debt

2011-12-16 05:00:01.6 GMT

By Miles Weiss

     Dec. 16 (Bloomberg) — David Einhorn, the hedge-fund

manager who compared the Greek bailout to a surrealist painting,

recast a bet against sovereign debt in a way that reduces risks

posed by government regulators and big banks.

     Greenlight Capital Re Ltd., a publicly traded insurer

controlled by Einhorn, held credit default swaps on $667 million

of sovereign debt as of June 30. During the third quarter, the

company exited about half of those swaps, designed to pay off

should a government default, and entered into short sales on

non-U.S. sovereign bonds, according to a regulatory filing.

     By replacing the swaps with short sales, Einhorn maintained

his ability to profit from a sell-off in government bonds while

avoiding potential pitfalls that he identified in a July 7

investor letter. Greenlight wrote that regulators were seeking

to prevent a triggering of credit default swaps tied to

sovereign debt, in part because the payouts could devastate

European banks that had agreed to provide the insurance.

     “There are at least three or four fairly large funds that

have done exactly the same thing as David Einhorn,” said Gary

Swiman, who heads the asset manager and brokerage division at

ICS Risk Advisors, a New York-based consulting firm. “You go

from a private market that is unregulated at this time to

publicly issued government sovereign debt that is transparent.”

     The net amount of swaps written on France, Greece, Italy,

Portugal and Spain declined to $66.8 billion at Dec. 2 from

$74.5 billion at Jan. 7, according to data from the Depository

Trust & Clearing Corp., a New York-based central repository for

credit swaps. The largest reduction was for Greece, which had

$3.4 billion of net credit swaps on its sovereign debt at Dec.

2, down 46 percent from $6.3 billion at Jan. 7.

 

                           Prices Soar

 

     Einhorn, 43, the president of New York-based Greenlight

Capital Inc., invests in companies he deems undervalued and also

makes wagers against those he considers overpriced, ranging from

Lehman Brothers Holdings Inc. in 2008 to Green Mountain Coffee

Roasters Inc. earlier this year.

     In addition to running hedge funds, an affiliate of his

firm helps invest the assets of Greenlight Re, a Cayman Islands

company that provides reinsurance to insurers by assuming some

of their policy risk in return for a share of premiums.

Greenlight Re’s holdings mirror those of Einhorn’s hedge funds,

according to a person familiar with the matter, who asked not to

be identified because the information isn’t public.

     Greenlight Re reported in an Oct. 31 filing with the U.S.

Securities and Exchange Commission that it sold credit swaps on

sovereign debt with a face value of $294.6 million during the

third quarter. The firm also sold short $153.8 million worth of

non-U.S. sovereign debt, according to the filing.

 

                        Premiums Increase

 

     Jonathan Gasthalter, a Greenlight spokesman, declined to

comment on the trades.

     Greenlight Re may have switched from credit swaps to short

sales of sovereign debt for a variety of reasons. These include

the possibility of realizing profit as the price of insuring

European sovereign debt soared during the third quarter.

     The annual cost for insuring $10 million of Italian

government bonds under a five-year contract, for example,

reached $534,370 on Sept. 22, up from $171,625 on June 30,

according to data compiled by Bloomberg. Greenlight Re

recognized $22.7 million of gains from its sovereign-credit

swaps during the third quarter after recording losses of about

$7.2 million during the first six months of last year, according

to its quarterly filings.

 

                       Interest Rate Bets

 

     In addition, short positions provide more profit potential

than credit swaps should interest rates rise and cause

sovereign-bond prices to decline.

     After adding the short positions, Greenlight Re said in

company filings that its “debt instruments” would have

increased in value by $11.5 million if interest rates had

increased by one percentage point on Sept. 30. As of June 30,

before the short positions were added, the comparable gain in

the company’s debt holdings from a one percent interest rate

increase would have been $82,100, the filings show.

     In a short sale, an investor borrows and then sells a bond

in the open market, hoping to profit by repurchasing it at a

lower price after the security declines in value.

     Credit swaps, similar to bond insurance, can be used to

protect investments or to speculate on a company’s

creditworthiness. An investor receives premiums from a second

investor in return for agreeing to make a cash payment to the

latter, equaling the face value of the bond covered by the

agreement minus any recovery value, should the issuer of the

debt suffer a setback such as bankruptcy or a ratings downgrade.

 

                         Difficult Trade

 

     “A CDS trade is in many ways economically equivalent to

simply shorting a bond and borrowing it for the term of the

trade,” said Jonathan Cooper, a senior consultant at Finadium,

a Concord, Massachusetts, research and consulting firm that

specializes in financial markets.

     Each type of trade has pros and cons, according to Cooper

and Swiman at ICS Risk Advisors. It’s hard to short a bond for

more than a few months, while credit swaps typically run five

years. On the other hand, credit swaps are private contracts and

require investors to rely on the creditworthiness of their

counterparty.

     “The other side of the trade is someone basically selling

you insurance,” Swiman said. “But when you can’t tell how

solvent they are and how much other CDS they have sold to other

counterparties, it creates fear.”

 

                       Treachery of Images

 

     Greenlight revealed some of its thinking in a July 7

investor letter that cites “The Treachery of Images,” a

painting by the Belgian surrealist Rene Magritte, in discussing

European efforts to avoid a Greek debt default.

     The letter touched on two risks tied to credit swaps on

European sovereign debt, including regulators’ attempts to

fashion a Greek bailout in a way that prevented the contracts

from paying out. The second risk was the possibility that banks

that wrote billions of dollars in credit swaps on sovereign debt

might not be able to make good on their obligations should a

country such as Greece actually default.

     Greenlight, citing French President Nicolas Sarkozy in

particular, noted that regulators were determined to prevent the

Greek bailout from being classified as a “credit event,” which

would trigger a payout to swap holders. Stating that “it is

very odd to hear a political leader use such technical jargon,”

Greenlight then asks in the letter “Why would Mr. Sarkozy do

this?”

 

                       ‘Enormous Exposure’

 

     The letter raises the possibility that French banks have

“enormous exposure” to sovereign-credit events. That’s because

banking regulations define sovereign credits as risk free,

allowing banks to take on as much sovereign-credit risk as they

wanted, perhaps by issuing credit swaps, without having to set

aside any capital.

     “Under such a structure, selling short CDS protection is

akin to free money for the banks,” Greenlight says in the

letter. “No one knows just how much aggregate exposure to

sovereign debt and CDS is hidden in the banking system, and no

one is itching to find out.”

     In late October, the European Union reached an agreement

where banks would write down their holdings of Greek bonds by 50

percent. The International Swaps and Derivatives Association’s

chief lawyer said because the deal is considered voluntary, it

won’t require firms that sold credit protection on Greece to pay

buyers of the swaps.

 

                        Default Illusion

 

     In describing the potential for this sort of outcome back

in July, Greenlight recalled that Magritte’s pipe painting

includes a caption that translates to “This is not a pipe.”

Magritte proved the image was not a pipe by telling doubters,

‘Just try to fill it with tobacco’.

     “As Magritte might say, ‘This is not a default’,”

Greenlight wrote. “Just try to collect on your credit default

swaps.”

 

For Related News and Information:

Top Stories:TOP<GO>

SEC Filings: EDGS

Hedge Fund News: NI HEDGE <GO>

Credit Derivatives: CDS <GO>

 

–Editors: Steven Crabill, Christian Baumgaertel

 

To contact the reporter on this story:

Miles Weiss in Washington at +1-202-624-1899 or

mweiss@bloomberg.net

 

To contact the editor responsible for this story:

Christian Baumgaertel at +1-617-210-4624 or

cbaumgaertel@bloomberg.net