The Hidden Risk on a “Hedged Position” | Elliott Wave International

Home > European Markets
The Hidden Risk on a “Hedged Position”
How the International Swaps Dealer Association crippled the sovereign bond credit default swaps market -- and why that matters to you

By Jason Farkas
Thu, 10 Nov 2011 14:00:00 ET

Get investable insights sent to your inbox at least once a week – for free. Challenge the way you think about investing with The EWI Independent.

Privacy

“If Private Santiago was to be transferred off the base, then why would he be in danger....Why the two orders?”

-- Lt. Daniel Kaffee, A Few Good Men

Jefferies & Co, Inc. just announced that they have reduced their holdings of European sovereign debt by $2.2 billion. But just last week -- and for months prior – many holders of European debt declared themselves to be “hedged” against any risks via credit default swaps (CDS).

Yet if Jefferies were hedged, then why would it need to reduce the position? In other words, why "the two orders?" You’re either hedged, or you’re not.

Here's what might be happening: Sovereign bond hedgers may be realizing they are much more at-risk now than they were previously. Why?

It's probably a result of last week's “voluntary” Greek bond haircut -- i.e., a reduction in how much the Greek bondholders will be paid back. The International Swaps Dealer Association (ISDA) declared the 50% haircut "voluntary," thereby technically making it a "non-default."

See, if Greece couldn't pay back 100% of the borrowed money, that would be an honest-to-goodness default. But because Greek debt bondholders (with much arm-twisting by the EU, ECB and IMF) agreed to accept 50 cents on the dollar before Greece formally said it's broke, it's a voluntary haircut. No "default" language around here, please!

But if the Greek haircut is “voluntary,” then any haircut for any other sovereign debt could be ruled a non-default, too. And since CDSs only protect the hedgers in case of bond defaults, this ISDA decision has effectively rendered the sovereign CDS market useless on at least the first 50% of losses.

Why should you care? Here's why.

Let’s say -- hypothetically, of course -- that many European banks hold sovereign bonds from Portugal and Italy. Prior to the “voluntary” ruling, rather than sell bonds at a loss, banks would buy CDS contracts as protection, so they’d be hedged if the bonds defaulted. But if the ISDA refuses to call haircuts “defaults,” then the CDS hedges stop working as intended. And so, the risk of falling bond prices becomes important again, making the nervous markets even more jittery.

You can see the irony: In an effort to decrease contagion from the Greek haircut, the ISDA, EU, ECB and IMF have unwittingly increased the contagion risk. By refusing to trigger CDSs on Greece, they have shrunken the pool of sovereign debt buyers, who are now less able to hedge their bets, and raised the pool of sovereign debt sellers.

You may wonder if there is an Elliott wave angle in all this. There is. Socionomics postulates that in bear markets, authoritarianism increases. But the authorities rarely make things better, because unintended consequences arise no matter what decision they make.

EWI president Bob Prechter wrote this about credit default swaps in the July 2011 Elliott Wave Theorist*:

“...if a deflationary crash is coming, [credit default swaps] won’t work. CDS issuers will default. There is no way out.”

The world is awash in debt which it can’t possibly repay, but the current power structure around the world has a vested interest in delaying that fact. The crumbling of the sovereign debt and its credit default swaps market fit right in with our view. Hedgers beware!

*The latest issue of Bob Prechter's Elliott Wave Theorist is now online. Here's what's inside >>

A chance reading of a book on technical analysis and the Austrian school of economics eventually led Jason Farkas, CMT, to Elliott Wave International. Prior to joining EWI, he worked for 14 years as a futures, options and equity trader. Jason is one of the analysts for EWI's forex-focused Currency Specialty Service.

Tags: debt crisis, debt downgrade, derivatives, European debt crisis, European Union (EU), eurozone, Greek debt

May 13-16

Las Vegas Money Show

July 10-13

Freedom Fest Conference

Get an Unconventional Yet Accessible Look at European Markets

The European Financial Forecast gives you an invaluable big-picture outlook for major European bourses to give you an edge over the investing herd.

Each monthly 10-page issue gives you timely, Elliott wave analysis and forecasts of the DAX, FTSE, CAC, Euro Stoxx 50 and more, plus commentary on economic and social trends.

Preview the Latest European Financial Forecast Now>>

Most Read

Highest Rated

Free Report

The European Debt Crisis

The European Debt Crisis is affecting investments across the globe. Our new free report offers commentary from February 2010 through November 2011 that will help you to better understand what could be in store in the coming months and years.
Download your FREE report now.

European Markets

CLOSE [ X ]

The Elliott Wave Principle is a detailed description of how financial markets behave. The description reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific Elliott wave patterns in price movements. Each pattern has implications regarding the position of the market within its overall progression, past, present and future. The purpose of Elliott Wave International’s market-oriented publications is to outline the progress of markets in terms of the Wave Principle and to educate interested parties in the successful application of the Wave Principle. While a course of conduct regarding investments can be formulated from such application of the Wave Principle, at no time will Elliott Wave International make specific recommendations for any specific person, and at no time may a reader, caller or viewer be justified in inferring that any such advice is intended. Investing carries risk of losses, and trading futures or options is especially risky because these instruments are highly leveraged, and traders can lose more than their initial margin funds. Information provided by Elliott Wave International is expressed in good faith, but it is not guaranteed. The market service that never makes mistakes does not exist. Long-term success trading or investing in the markets demands recognition of the fact that error and uncertainty are part of any effort to assess future probabilities. Please ask your broker or your advisor to explain all risks to you before making any trading and investing decisions.