David Einhorn, the hedge-fund manager who compared the Greek bailout to a surrealist painting, recast a bet against sovereign debt in a way that reduces risks posed by government regulators and big banks.
Greenlight Capital Re Ltd., a publicly traded insurer controlled by Einhorn, held credit default swaps on $667 million of sovereign debt as of June 30. During the third quarter, the company exited about half of those swaps, designed to pay off should a government default, and entered into short sales on non-U.S. sovereign bonds, according to a regulatory filing.
By replacing the swaps with short sales, Einhorn maintained his ability to profit from a sell-off in government bonds while avoiding potential pitfalls that he identified in a July 7 investor letter. Greenlight wrote that regulators were seeking to prevent a triggering of credit default swaps tied to sovereign debt, in part because the payouts could devastate European banks that had agreed to provide the insurance.
“There are at least three or four fairly large funds that have done exactly the same thing as David Einhorn,” said Gary Swiman, who heads the asset manager and brokerage division at ICS Risk Advisors, a New York-based consulting firm. “You go from a private market that is unregulated at this time to publicly issued government sovereign debt that is transparent.”
The net amount of swaps written on France, Greece, Italy, Portugal and Spain declined to $66.8 billion at Dec. 2 from $74.5 billion at Jan. 7, according to data from the Depository Trust & Clearing Corp., a New York-based central repository for credit swaps. The largest reduction was for Greece, which had $3.4 billion of net credit swaps on its sovereign debt at Dec. 2, down 46 percent from $6.3 billion at Jan. 7.
Einhorn, 43, the president of New York-based Greenlight Capital Inc., invests in companies he deems undervalued and also makes wagers against those he considers overpriced, ranging from Lehman Brothers Holdings Inc. in 2008 to Green Mountain Coffee Roasters Inc. earlier this year.
In addition to running hedge funds, an affiliate of his firm helps invest the assets of Greenlight Re, a Cayman Islands company that provides reinsurance to insurers by assuming some of their policy risk in return for a share of premiums. Greenlight Re’s holdings mirror those of Einhorn’s hedge funds, according to a person familiar with the matter, who asked not to be identified because the information isn’t public.
Greenlight Re reported in an Oct. 31 filing with the U.S. Securities and Exchange Commission that it sold credit swaps on sovereign debt with a face value of $294.6 million during the third quarter. The firm also sold short $153.8 million worth of non-U.S. sovereign debt, according to the filing.
Jonathan Gasthalter, a Greenlight spokesman, declined to comment on the trades.
Greenlight Re may have switched from credit swaps to short sales of sovereign debt for a variety of reasons. These include the possibility of realizing profit as the price of insuring European sovereign debt soared during the third quarter.
The annual cost for insuring $10 million of Italian government bonds under a five-year contract, for example, reached $534,370 on Sept. 22, up from $171,625 on June 30, according to data compiled by Bloomberg. Greenlight Re recognized $22.7 million of gains from its sovereign-credit swaps during the third quarter after recording losses of about $7.2 million during the first six months of last year, according to its quarterly filings.
Interest Rate Bets
In addition, short positions provide more profit potential than credit swaps should interest rates rise and cause sovereign-bond prices to decline.
After adding the short positions, Greenlight Re said in company filings that its “debt instruments” would have increased in value by $11.5 million if interest rates had increased by one percentage point on Sept. 30. As of June 30, before the short positions were added, the comparable gain in the company’s debt holdings from a one percent interest rate increase would have been $82,100, the filings show.
In a short sale, an investor borrows and then sells a bond in the open market, hoping to profit by repurchasing it at a lower price after the security declines in value.
Credit swaps, similar to bond insurance, can be used to protect investments or to speculate on a company’s creditworthiness. An investor receives premiums from a second investor in return for agreeing to make a cash payment to the latter, equaling the face value of the bond covered by the agreement minus any recovery value, should the issuer of the debt suffer a setback such as bankruptcy or a ratings downgrade.
“A CDS trade is in many ways economically equivalent to simply shorting a bond and borrowing it for the term of the trade,” said Jonathan Cooper, a senior consultant at Finadium, a Concord, Massachusetts, research and consulting firm that specializes in financial markets.
Each type of trade has pros and cons, according to Cooper and Swiman at ICS Risk Advisors. It’s hard to short a bond for more than a few months, while credit swaps typically run five years. On the other hand, credit swaps are private contracts and require investors to rely on the creditworthiness of their counterparty.
“The other side of the trade is someone basically selling you insurance,” Swiman said. “But when you can’t tell how solvent they are and how much other CDS they have sold to other counterparties, it creates fear.”
Treachery of Images
Greenlight revealed some of its thinking in a July 7 investor letter that cites “The Treachery of Images,” a painting by the Belgian surrealist Rene Magritte, in discussing European efforts to avoid a Greek debt default.
The letter touched on two risks tied to credit swaps on European sovereign debt, including regulators’ attempts to fashion a Greek bailout in a way that prevented the contracts from paying out. The second risk was the possibility that banks that wrote billions of dollars in credit swaps on sovereign debt might not be able to make good on their obligations should a country such as Greece actually default.
Greenlight, citing French President Nicolas Sarkozy in particular, noted that regulators were determined to prevent the Greek bailout from being classified as a “credit event,” which would trigger a payout to swap holders. Stating that “it is very odd to hear a political leader use such technical jargon,” Greenlight then asks in the letter “Why would Mr. Sarkozy do this?”
The letter raises the possibility that French banks have “enormous exposure” to sovereign-credit events. That’s because banking regulations define sovereign credits as risk free, allowing banks to take on as much sovereign-credit risk as they wanted, perhaps by issuing credit swaps, without having to set aside any capital.
“Under such a structure, selling short CDS protection is akin to free money for the banks,” Greenlight says in the letter. “No one knows just how much aggregate exposure to sovereign debt and CDS is hidden in the banking system, and no one is itching to find out.”
In late October, the European Union reached an agreement where banks would write down their holdings of Greek bonds by 50 percent. The International Swaps and Derivatives Association’s chief lawyer said because the deal is considered voluntary, it won’t require firms that sold credit protection on Greece to pay buyers of the swaps.
In describing the potential for this sort of outcome back in July, Greenlight recalled that Magritte’s pipe painting includes a caption that translates to “This is not a pipe.” Magritte proved the image was not a pipe by telling doubters, ‘Just try to fill it with tobacco’.
“As Magritte might say, ‘This is not a default’,” Greenlight wrote. “Just try to collect on your credit default swaps.”