Will hedge fund holdouts scuttle Greek swap deal?

Date: Wednesday, January 18, 2012
Author: Emily Flitter, Reuters

Hedge funds holding Greek bonds that mature in March may have the strongest hand in the critical negotiations to restructure the cash-strapped country's debt.

The Greek government wants to swap out that maturing debt for new, lower-yielding bonds and a small cash payment. But some hedge funds in London and New York that have snapped up chunks of Greece's next big maturing bond, the March 20, for around 40 cents on the euro, are balking.

There are fears the objections of some funds could make a restructuring deal difficult. Talks with Greece's creditor banks broke down on Friday over the interest rate on new bonds Greece will offer and a plan to enforce investor losses. Negotiations were suspended until Wednesday.

It is not clear just how big a force the funds actually are in the negotiations. Sources inside the hedge fund community say the amount of the 14.5 billion euro March 2012 issue currently held by hedge funds may not be that large

Still, cash-strapped Athens needs to treat the hedge funds as a potential threat to a deal with the clock quickly ticking down toward the deadline for a default.

The hedge funds stand to make more money if a default occurs. But they stand to gain something even without a default because of the credit protection they have purchased.

AVOIDING THE CDS TRIGGER

"The policymakers don't want to reward the hedge funds for their perceived participation in the sovereign problem," said Ira Jersey, interest-rate strategist at Credit Suisse in New York.

The conflict with the hedge funds puts Credit Default Swaps, derivatives that drew a great deal of attention for their role in the 2008 financial crisis, back in the spotlight.

CDS, agreements that allow bondholders to collect the original value of a defaulted bond, were supposed to make holding Greek debt safer. But the prospect of the voluntary swap has rendered some of the contracts worthless, leaving investors out the initial fee they paid to purchase the agreements.

Investors holding CDS were supposed to be able to win in the Greek play no matter how it ends. Either they collect high interest rates from the Greek government, or -- if the government cannot repay the debt and has to default -- they collect the par value of the bonds they bought cheaply during the euro zone debt crisis.

The cost of buying CDS on debt issued by Greece and other European countries has risen steadily since the crisis began. That means investors who bought Greek debt lately had to pay dearly to hedge their exposure.

Since the debt swap is voluntary, it will not be considered a default. There will also be far less of a return on the bonds being swapped out, since the point of the swap is to dramatically lessen the debt burden on the Greek government.

The March 2012 issue matters most. Because of the way CDS contracts are structured, some of the investors holding CDS on Greek bonds have only a year in which to collect on them in the case of a default. After a year, the money spent buying a one-year CDS contract is lost.

Some of the investors holding Greek debt say the loss they will have to take in the swap is too steep. One hedge fund manager calculated that with 50 percent of the bond's value gone in the swap, 15 percent of the remaining value paid out in cash and 35 percent handed over in the form of new, lower-yielding bonds, the March 2012 bonds are not worth holding.

"If the haircut that's being asked of the group were only 50 percent or only 60 percent or only 65 percent in real dollar terms, it might make economic sense to be part of it," the manager said.

"Most people think that the deal that's being discussed now would lead to a net present loss of more like 75 cents. Most investors think that's too steep."

For bonds with maturities later than March, the problem lies in the potential for the Greek government to retroactively scale back the value of its side of the swap, another hedge fund trader said. If Greek bondholders were to push the government into actual default, collecting on anything would be close to impossible.

"What's recovery going to be?" said the trader, who is following the talks but not participating in the trade. "That depends on whether Greece leaves the euro, how long it takes to play out in Greek court. I wish you all the best of luck in Greek court."