What drives hedge funds which buy Greek debt?

As Greece prepares a legislation to force all private bondholders to take losses on its debts as part of an ECB-EU-IMF rescue package, the hedge funds appear to be playing a game of brinkmanship with Greece.

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in a human rights court to make good on its bond payments. The novel approach would have the funds arguing in the European Court of Human Rights that Greece had violated bondholder rights, though that could be a multiyear project with no guarantee of a payoff.

One of the terms of the 130 billion euro ($165.5 billion) rescue package for Greece, is to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange. In addition, the Greek government is unwilling to offer the 4% interest rate on new bonds received in exchange for the old bonds. Hedge funds argue that this will effectively increase the relative haircut to between 60-70%.

Though Greece has been negotiating with its bond holders on voluntary haircuts, in the range of 50% of the debt value, these talks have made little headway. The EU-ECB-IMF had made such haircuts and consequent debt restructuring a mandatory requirement for releasing the next instalment of rescue package funds for Greece.

Many of the bondholders - hedge funds, pension funds, banks, etc - have already insured their positions through credit default swaps and find the deal offered by Greece less attractive than a forced default. But a forced haircut would unnerve the markets and potentially destabilize the global financial markets.

Interestingly, over the past year, despite there being ample evidence of Greece being close to default, several hedge funds have continued to buy into Greek debt. All of them were ttracted by the massive potential returns despite the potential for default and a perceived belief that EU and ECB would let Greece default. A Times report nicely captured the incentives,

"Greece may never be able to pay off its huge debts, but its bonds, long scorned by investors, are suddenly being gobbled up by hedge funds... many have turned their attention to the hot yet risky euro zone trade of the moment: buying Greek government bonds that traders say are changing hands for as little as 36 cents for each euro of face value. The investors hope to book a fat profit on the expectation that the European Union and the International Monetary Fund will once again bail out Greece, fearing a global financial disaster if they do not...

Those speculating in Greek bonds are taking on well-documented risks, not the least of which is the possibility that the country will fail to reach a final agreement with the I.M.F. and the European Union and will not get the next portion of money needed to avoid default."

In fact, a major portion of the current bond holders are not the original ones - large European banks - and are speculative investors who have purchased their bonds in recent months. The Times report estimated that as on September 2011, about 30% of the investors bought their bonds after July 21. This share would surely have climbed in the subsequent months.

I have two observations from these events.

1. The hedge fund managers are obviously playing chicken with Greece and Eurozone. Who will be the first to blink? If they are able to scare Greece, EU, ECB, and the IMF away from forced default and/or to get the IMF and EFSF/EU to accept losses, by amplifying fears of a global financial market contagion (driven by bond market vigilantes), then the hedge funds stand to make fantastic gains. Conversely, the governments could call the bond market bluff and proceed with the haircuts and debt restructuring, thereby imposing serious costs on the hedge funds.

2. The action of the hedge funds in buying into Greek debt despite clear knowledge of all the associated risks bears remarkable similarity to the role of real estate agents in India who scout for lands emrboiled in litigation or whose titles are not clear.

Such lands, embrolied in litigation or uncertainty for many years, even decades, cannot be developed without settling the encumberances by clearing the title. Real estate agents with close political connections see them as opportunities. They buy into these lands, including the litigation, at cheaper than the market rates. Then they use their official connections to either weaken government claim (for example, by making the government advocates soft-peddle on court litigation) and eventually get it transferred to private interests or use political muscle power to arm-twist the other private parties into signing away their interests at a bargain rate.

Such agents, who are present in all Indian cities, and have connections with influential people in the establishment - politicians, officials, and judges - are classic risk managers. They spot the opportunity, weigh pros and cons - risks associated with getting the title cleared off encumberances - and make their investments.

The modus operandi is eerily similar to that of the hedge fund managers who have invested in Greek debt despite enough evidence that Greece would default on its sovereign obligations. Like the real estate agents, all these hedge fund managers wield considerable influence in the corridors of power - governments, central banks, financial market regulators, and big financial institutions. Again, like them, the real estate agents try to leverage this influence to benefit them. In fact, they become confident that with an appropriate mixture of brinkmanship and nudging of the powers-that-be who decide on the terms of the Greek default, they would be able succeed with a favorable debt restructuring deal.

These real estate agents operate purely outside the legal boundaries. However, the trades executed by hedge funds, in the face of very obvious and extreme risks, are perfectly legal. Is there a case for atleast some regulation on such trades?

In the instant case, it was plain obvious, as early as early last year, that haircuts on Greek debt was inevitable. In the circumstances, the only logical reason for hedge funds to pile into Greek bond was a belief that they could influence the debt restructuring process. Given the moral hazard and other incentive distortions created by these actions, is there a case to restrict such trades, especially under such conditions?

Supporters of these trades will obviously point to their positive role in risk diversification by helping banks off-load risks to those best able to bear them. But then this diversification becomes a double-edged sword when the buyers do so on the aforementioned assumptions. Systemic risk then gets amplified instead of being diversified.

Post script - As for Greece itself, even with the deal, its debt would be no less than 120% of GDP in 2020 (down from 140% of GDP at $450 bn today) — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

Hedging away stock option risks

One of the important strands of executive compensation reform in the aftermath of the sub-prime crisis was to shift more compensation into long-maturity stock options. This was intended to align employees’ interests more closely with those of investors and discourage excessive risk-taking. It was hoped that this would expose them to the long-term risk of that investment, which would incentivize them to work towards the longer-term health of the firm.

It now emerges that executives have been getting around this issue by hedging their downside on their holdings using complex investment transactions. Hedges allow employees to limit losses, raise cash, or diversify their portfolios without selling the underlying holdings. And no surprises for guessing who is leading the way - executives from Goldman Sachs (sample the Collar hedge below which while capping the potential upside also limits losses)!



Though most public companies, including Wall Street firms, have policies that ban hedging, albeit only their most senior executives, the practice is widespread at the lower levels. However, such hedges often put the executives interest in direct conflict with those of their company.

It is clear that reforming executive compensation is far from easy. Financial market reform is at best a moving target. Regulators and policy-makers have to be quick to respond to emergent distortions, if not be one-step ahead of the market. In practical terms, this means that instead of one-time enactments, they need to have legislations and rules that are constantly evolving in response to emergent scenarios.

Greed Wasn't Enough

"There was too much greed on Wall Street. Greed destroyed us." How many times have we heard that greed was the center of all the ills of Wall Street, Main Street, and Global Street? Can it really be that simple? After all, isn't greed part of the common human condition?

I like to think that Policy Innovations is ahead of the curve. Another case appeared today in the New York Times op-ed section. In an essay titled "The End of the Financial World as We Know It," Michael Lewis and David Einhorn argue that greed is not a sufficient explanation of the current mess. Instead, more robust factors involved were:

1. Misaligned interests of the many
2. The tyranny of the short term has prevented institutions from doing their job
3. Our enlightened self interest was therefore hindered

Here is an excerpt from their essay:

Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.

OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.

Lewis and Einhorn suggest empowering people within organizations--so called whistleblowers. Here is part of a Policy Innovations piece by Stanley Goldstein and Frank Plantan from late Dec. 2008:

Peer pressure and standard business usage can nudge the managers of hedge funds to set standards of conduct and ethical behavior out of enlightened self-interest.

Many charities today are adopting whistleblower policies and creating audit committees within their boards of directors. There was no mandate behind this promulgation. Rather it was the questions that grantors had begun to ask that led to their creation. After repeated queries regarding whistleblower and corporate governance policies, charities caught on to the fact that it is better to attend to these issues as a means to attract funding.

The ultimate goal of such behavior is to reap the value of a good reputation. The voluntary adoption of these policies has a direct impact on a charity's ability to instill confidence in funders. Most charities would prefer to avoid such expenditure of time and resources, but consumer and client demands make it a necessity.

Chimerica Convergence: Ethical Bailout Needed

During our recent trip to Beijing (see video above), many people made the joke that just as China was becoming capitalist, the United States was going to nationalize its financial system. Which one was really socialist, some asked us? Some Chinese found America's movement back toward a socialized financial system to be frustrating: What is our benchmark? What is our goal? The target keeps moving, it seems.



More telling, perhaps, is that America and China are converging--Chimerica, as Niall Ferguson has called it (see video above at Carnegie Council's Public Affairs program).

Thomas Friedman made this point this week in his op-ed "The Great Unraveling:"

But while capitalism has saved China, the end of communism seems to have slightly unhinged America. We lost our two biggest ideological competitors — Beijing and Moscow. Everyone needs a competitor. It keeps you disciplined. But once American capitalism no longer had to worry about communism, it seems to have gone crazy. Investment banks and hedge funds were leveraging themselves at crazy levels, paying themselves crazy salaries and, most of all, inventing financial instruments that completely disconnected the ultimate lenders from the original borrowers, and left no one accountable. “The collapse of communism pushed China to the center and [America] to the extreme,” said Ben Simpfendorfer, chief China economist at Royal Bank of Scotland.

Coincidentally, Friedman comes to the same conclusion that we found on our trip to Beijing: The United States and the world need an "ethical bailout:"

The Madoff affair is the cherry on top of a national breakdown in financial propriety, regulations and common sense. Which is why we don’t just need a financial bailout; we need an ethical bailout. We need to re-establish the core balance between our markets, ethics and regulations. I don’t want to kill the animal spirits that necessarily drive capitalism — but I don’t want to be eaten by them either.

We need a balance between ethics and regulations. Policy Innovations makes a similar point in our latest financial commentary, "Raising the Bar for Hedge Funds," by Stanley Goldstein and Frank Plantan. Check it out here.