The New Big Short – against the euro, that suggests France is riskier than Panama

It was Michael Lewis who famously described the top hedge funds making billions from piling in against the subprime mortgage lending as “The Big Short”. Put aside for a minute that many of those same hedge funds are now fairly substantially down in value on the year, even when valued in gold.

Well having spent a week in New York, there’s a new big bet from the US hedge funds that has proven recurrently profitable over the past year: shorting the single currency. To be clear, it is not actually shorting the euro. As I understand the wisdom in the markets is that actually shorting the euro in currency markets is far too risky, in case the PIIGS are kicked out of the euro, and it basically becomes a 21st Century Deutsche Mark. No, the way to get at this trade most efficiently, and with maximum leverage is via the famous Credit Default Swaps market.

Yes, that’s the famous CDS market that through AIG Financial Products unbelievable trading activity nearly threatemed to bring down half of Europe’s banking system in 2008. It’s the same CDS market that George Soros had previously told me was “the sword of Damocles” hanging over the market.

These days it can be used, perfectly legitimately to gain from the demise of the euro periphery. Its a form of insurance against a government going bankrupt. Here’s how you make your millions:
Step 1: Buy an insurance policy against say Greece defaulting when the risk was low, at say 300 basis points, or a 3 per cent premium
Step 2: Wait as risk of Greece bankruptcy skyrockets
Step 3: sell an insurance policy back when the risk is high, the spread at 1500 basis points, or 15 pc premia, at vast profit
And Step 4: Repeat with other euro countries

With the added magic dust of using banks money to supersize these bets, traders told me that you could make returns of 800 to 1000%.

The only issue is Step 2. Many senior bond market participants think that the very act of buying the insurance aggressively in markets that are less liquid than that of the underying bonds, actually contributes directly to the escalation of government bond yields, and the sense of fear and panic. The market has at least an element of dangerous circularity.

Jim Rickards, who I interview in my report, used to work for Long Term Capital Management. He describes what’s going on as a “pinata party” where hedge funds bash Greece, Italy, etc. And then watch as the money drops out. He worries that the practice has “national security implications and is “attacking an important Nato ally”. Specifically it is the naked CDS, which are trades made by those with no actual interest in the underlying bonds that he feels should be banned. He is not alone. So does Germany, and the European Parliament. The basic idea: why allow someone with no insurable interest to take out say fire insurance on someone elese’s house? It is an incentive to burn down someone else’s house.

But what about the US? well naked CDS were illegal under anti-gambling laws until the US Commodity Modernisation Act of 2000 was passed and gave the product specific exemptions. I will look into how the deregulation occurred in Europe.

The case against CDS and naked CDS is clearly mixed. German regulators did not find a key role in Greece’s demise. Obviously these bets are only possible becase of 1. Fiscal excess, 2. The fact that the PIIGS can’t print their own money, 3. The fact that Germany is dithering over writing cheques. Some argue it gives extra price signals.

But is France really more of a risk than Panama, as CDS markets declared last week? Is Kazakhstan less creditworthy than Spain, as Lawrence Macdonald told me on Wall Street last week. Even the Chancellor of the Exchequer has taken to quoting various positive CDS numbers for Britain in recent days.

But the market is far from efficient, well away from being perfect, and some argue, is dangerous. Others say it is a far more honest market-based reflection of creditworthiness, at a time when France is rated a better credit than the US by the traditional ratings agencies.

My view: watch the CDS market very carefully. And also keep an eye on the battle of wills between US hedge funds and EU politicos