Speculators are back in the news, at least in Spain. Could there be something behind the claim by José Blanco, Spain’s development minister, of a conspiracy by international markets to bring down the euro? Frankly, no.
What there is, though, is valid concern among some serious investors that regulators could step in to help save the euro. The spread over German Bunds of Greek, Spanish, Portuguese, Irish and Italian CDS has soared as investors use the CDS to bet against the price of the bonds (CDS= credit default swaps, labelled financial weapons of mass destruction by Warren Buffett, and the Monster that ate Wall Street by Newsweek. They are basically a side bet on the performance of a bond, a type of insurance policy which pays out if the company or country which issued it defaults).
Take the parallel with the banks. US regulators ignored CDS when they stepped in to stop shorting of bank equities in 2008. But in the UK, the FSA banned all forms of shorting – including taking net short CDS positions.
Could something similar be done to try to rescue Europe’s struggling periphery? It doesn’t seem that likely that the British, and certainly not the Americans, would want to step in. After all, there are valid reasons to be worried, as the countries being hit are all in deep financial trouble and have no opportunity to devalue.
But the risk is there. One manager of a big hedge fund told me he closed out all his short positions on the euro and eurozone government bonds to avoid being caught out by any action – even though he knew this would mean missing out on profits.
“There’s a chance of a regulatory backlash,” he told me.
Other hedge funds don’t seem to care too much: short positions on the euro are at record levels.
Leaving aside the likelihood of a politically-driven intervention, are the CDS really causing the problem? George Soros, the man who broke the Bank of England and forced Britain out of the ERM, argued that CDS were behind the banking crisis, both because they provided a signal to customers that a bank might be in trouble, and because they encourage speculation on the short side, but discourage it on the long side (although note that this is controversial).
Could Soros’ argument apply in sovereign debt? To some extent, yes. Higher borrowing costs do themselves threaten the solvency of the country, and the bias towards shorting built in to CDS (if you accept it) applies in just the same way. On the other hand, the signalling effect will not drive away “counterparties” of countries the way they do with banks, because countries do not have any. But the signalling does raise political issues, as we are seeing in Spain right now.
It is this political backlash which could leave hedge funds exposed if regulators are pushed into surprise action against the CDS. Soros and many others argue that CDS should only be used to protect against bonds the investor actually owns, not for pure speculation. Such a move would catch a lot of hedge funds short.