Fear and loathing as the hedge funds take on the euro

Gigantic bets against the euro have fuelled rumours of a hedge fund plot to cash in on the Greek crisis

Sean O'Grady
Thursday 04 March 2010 01:00

Fears of a hedge fund "conspiracy" to destroy the euro gathered pace yesterday when the American authorities ordered some funds not to destroy records of their trading in the single currency. The move comes after the US Federal Reserve promised to probe claims that the use of credit derivatives by Goldman Sachs had, ironically, helped Greece enter the eurozone a decade ago. Although the latest Greek austerity plan helped to calm markets and nudged the euro higher against the dollar, traders warned that the euro's traumas were far from over. Indeed, it seems that the EU and the hedge funds are about to intensify their economic warfare, with the opening of a new front in America.

The US Department of Justice has asked a number of the hedge funds whose executives attended a dinner hosted by New York-based research and brokerage firm Monness, Crespi, Hardt & Co on 8 February, to preserve their trading histories. According to an agenda obtained by Bloomberg, those present discussed a number of "themes", including the chances of the euro falling against the dollar. Aaron Cowen, an executive at SAC Capital Advisors, David Einhorn, head of Greenlight Capital, and Don Morgan, who runs Brigade Capital Management LLC went to the dinner, as did a representative from Soros Fund Management.

The presence of a Soros employee has set alarm bells ringing, as George Soros' formidable reputation as an investor – as well as a maker and breaker of currencies – goes before him. So far-reaching is his influence that any hint from him of negative sentiment towards an asset or currency can turn into a self- fulfilling prophecy.

While the meeting may have been no more than an exchange of ideas, with no commitments on any side, the presence of so many powerful American financial interests in one room discussing the euro will no doubt fuel the conspiracy theories currently swirling around the foreign exchange markets and in political circles.

The Greek prime minister, George Papandreou, has condemned speculators with "ulterior motives" for making his country's difficulties worse and destabilising the euro. If the dinner meeting in New York was part of a concerted effort to move markets it might well break US anti-trust laws. Conversely, other hedge funds have said they have avoided euro denominated sovereign debt for fear of regulatory retaliation.

The forces are massing. The value of the "bets" made by hedge funds and others against the European currency has reached more than $12bn – almost double the amount of a few weeks ago, suggesting that the pressure will persist. The number of credit default swap (CDS) contracts made to the same effect has also soared.

Many CDSs – in effect a means of insuring against the risk of default – have been taken out by those with no ownership of the underlying asset, such as Greek government bonds, in so called "naked" CDS trading. Very low interest rates provided by central banks have also made such bold currency plays more viable, as they reduce the cost of funding or "covering" them.

For the moment though, the euro seems set to survive its Greek calamity. A swingeing programme of VAT rises and public sector wage cuts were widely rumoured to be the price Greece will have to pay for the long-mooted EU bailout of around €25bn. It should also clear the way for a successful €5bn bond issue at the end of the week. As was widely anticipated, Athens yesterday announced a further €4.8bn in fiscal consolidation, about 2 per cent of GDP, in the third package in three months. There will be a rise in VAT, further tax hikes on fuel, alcohol and tobacco, and more reductions in the public-sector wage bill.

This is in line with the demands European finance ministers have been making on their Greek counterpart. Yesterday's plan also had a positive effect on the cost of insuring Greek government debt, which fell back again. However, a further €20bn will need to be raised by Greece over April and May, and more explicit assurances that the other eurozone states will stand by Greece financially may be needed.

The anticipation of a deal between Athens, Brussels and the two nations liable for much of the bill – France and Germany – was also heightened by the announcement that Mr Papandreou will meet Chancellor Merkel this Friday before seeing President Sarkozy on Sunday. By the time Mr Papandreou faces all his fellow EU leaders in Brussels on 16 March he should be able to demonstrate concrete progress towards his stated ambition of getting Greece's near 13 per cent of GDP budget deficit down to 9 per cent next year and back below the Lisbon Treaty limit of 3 per cent by 2012.

However, mutual suspicion and name-calling between the hedge funds and regulators on both sides of the Atlantic still threatens to escalate into something more serious.

The EU's new Internal Market Commissioner, Michel Barnier, said this week that he would investigate short sales of the euro and the abuse of the credit default swaps market. He is currently supervising the Commission's latest directive to regulate the hedge fund industry, the alternative investment fund managers (AIFM) directive. This measure has the potential to kill the EU hedge fund business, which is 80 per cent concentrated in London.

Clauses in the draft AIFM directive that require regulatory equivalence in territories where hedge funds usually domicile their money, such as the Cayman Islands or Jersey, would effectively end many hedge funds' life in the EU. And it is a substantial business. European hedge funds, predominantly in the UK, grew by 9.1 per cent in the second half of last year to reach $382bn, according to Hedge Fund Intelligence, part of a global wave of almost $2trillion, more than enough to move certain assets or currencies, especially if leveraged with cheap central bank money.

Lord Turner, the chairman of the Financial Services Authority said on Tuesday he backed an investigation into short speculative positions. He said: "It may be that even if you banned it, it wouldn't make a big difference, but there are questions as to whether you should be allowed to take out an insurance contract where you don't have an insurable interest."

The French Finance Minister, Christine Lagarde, has said she wants the EU to take a united approach against "speculators" betting on CDSs, and the German Finance Ministry has also called for review of "over-the-counter" products such as CDSs, which are not traded on any central exchange and, arguably, lack transparency.

Such sabre rattling is yielding results. Some hedge funds, including Brevan Howard and Moore Capital, have avoided euro-denominated sovereign debt because of the threat of a "regulatory squeeze", though they may continue to take a position against the euro itself.

Brevan Howard, Europe's largest hedge fund, with $27bn of assets under management, has said the short trade in eurozone government bonds was "extended, crowded, fully pricing the fundamentals", and indeed the CDS spreads for Greek paper have been narrowing markedly in recent weeks. The firm added that the hedge funds were facing the same sort of pressure over short-selling activity that they did at the peak of the crisis on 2008, when they were banned temporarily in some places from going short on bank shares, something that had little long-term effect on the fate of the banks.

In the war between the hedgies and the authorities, many observers believe that Spain, rather than Greece, will prove the decisive battle ground. As Spain's economy is so much larger than that of Greece, a bailout would be far more difficult to fund even for the zones largest economy Germany, where political resistance to further rescues may be insurmountable.

In the long term, the resolution of this struggle may be political rather than economic. Mr Papandreou has suggested speculation against individual nations would be rendered impossible if sovereign debt was issued by a European Treasury on behalf of all states, just as the US Treasury does. President Sarkozy has also spoken enthusiastically and often about the need for "European economic governance".

But a pooling of budget and Treasury functions across the zone would remove the last defences of German fiscal prudence: the others have gone. The Maastricht criteria, transferred to the Lisbon Treaty, limited budget deficits, national debt levels and outlawed cross-border bailouts; All have been, or may shortly be, swept away by the financial storm. The hedge funds are, in part, betting that the German government, or its people, will prefer to preserve their treasured economic security rather than the cherished political project of European unity.

As so often during momentous episodes in European history, it all depends on Berlin.

George Soros: The man that governments fear

The involvement of George Soros in the euro crisis has revived uncomfortable memories of the success – and profits – he enjoyed by betting against the pound during the ERM crisis of 1992. "The man who broke the Bank of England", he was soon dubbed, and he reputedly made $1bn from his activities then; the concern is that he will now break the euro. The influence of the Hungarian-American currency speculator, stock investor and philanthropist is such that he attracts many followers, and his bets can thus become self-fulfilling through "momentum trading". Even if he does not actually destroy the eurozone, he will leave it badly mauled.

The auguries are not good. At the Davos World Economic Forum in January, Mr Soros declared that he thought the euro "may not survive". And if there is one theme in his long career it is that he enjoys making one way bets on economic inevitabilities; often the certainty that a fundamentally weak currency will have to leave a fixed exchange rate system (as with the pound in 1992). By the spring of 1992, it was becoming clear that Britain was a part of the European Exchange Rate Mechanism at the wrong rate. It was overvalued compared to the German currency, and we were increasingly uncompetitive. The only way it could be sustained was for British interest rates to be kept far too high for UK domestic conditions (though that did hammer inflation out of the system). The pain the ERM was causing, unnecessarily, to the British economy, was becoming unbearable. Soros spotted his chance.

In retrospect, he followed what was an obvious strategy. In this case, he borrowed around £6bn and converted it to German marks at the fixed rate, shorting his sterling position. It was almost a one way bet. If sterling collapsed he would hit the jackpot. He hit the jackpot. A £350m side bet on equities rising after the devaluation was a bonus.

The Tory government led by John Major was humiliated for its economic incompetence, and was left out of contention for two decades. The political advisor to the then chancellor, Norman Lamont, was a certain David Cameron. One can guess the lessons he learned from the experience.

Almost 80 now, Mr Soros has been a pantomime villain ever since, but he perhaps did the UK a favour. "Black Wednesday", 16 September 1992, heralded a savage depreciation of sterling followed by a long period of sustained low inflation and export-led growth. The Greeks could do a lot worse.

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