Events Trader #55: 2 great trades on Greece going bust

18th May 2010

2 great trades on Greece going bust

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It didn't take long for the euphoria to wear off. Not a week after the European authorities shook hands on a €750bn bailout for Greece, the Euro has resumed its horrific downward spiral hitting a four year low against the dollar.

And investors are right to panic. This bailout does nothing but buy the Greek and German authorities a bit of time. The real problem is that the Greeks are not going to be able to hold up their side of the bargain. They just have way too much debt. And too many factions who are willing to go on the rampage as soon as the government tries anything heavy handed.

That's bad news for the Greek economy. But even worse for anyone who is left holding their debt.

And that's what I want to talk about today. Because I think we will be able to make some great trades out of this massive, unwinding crisis.

Today I want to talk about who is most exposed to toxic Greek debt. And two great ways for us to trade what could be another devastating banking crisis in Europe.

Why €750 billion isn't enough

Let's go back to the start for one minute. Why have Greece's debt problems suddenly become such an issue? Well the recent problems started when rating agency Standard & Poors downgraded Greek debt to junk status.

That meant that a whole swathe of investment funds had to offload Greek debt (most are restricted from holding junk bonds on behalf of their investors). And rates on Greek bonds soared over night. Panic spread through Europe quicker than wildfire. And the authorities were forced into announcing a remarkable €750 billion rescue package.

But there are very good reasons why the markets are already nervous about this rescue package. First, it requires the Greek government to be tough and implement nasty budget cuts to meet the debt agreement. Personally, I don't think the Greek government has the guts to push through these painful cuts.

But they are not even going to be given a chance if recent events in Athens are anything to go by. The general Greek population seems to still live in cloud cuckoo land. While the Irish and the Latvians (and soon the British) seemed resigned to take cuts in order to save the economy, the Greek population is showing no understanding.

Ultimately, the Greeks won't pay their debt. They are simply unable to do so. And that leaves us with two scenarios as far as I can see.

Greece will still go bust

First outright default. The Greeks decide to go it alone. And just like Argentina in the nineties, investors scramble to get back 30-50% of the value of their outstanding bonds, some years from now. This measure would be enough to solve the immediate problems by substantially reducing its debt. But it would make future borrowing very hard and the damage to the banking system would be immense. That leaves.

Option two - a major restructuring of Greek debt. This is the far likelier scenario as far as I'm concerned. In this scenario, those holding Greek debt will be asked to receive less (maybe 80%) on their bonds in exchange for support and continued lending - similar to a prepackaged Chapter 11 where lenders exchange their claims for a stake in new company.

Why would they do this? Because they won't have a choice. The truth is that European banks are sitting on billions of dodgy Greek debt. And the German and French governments can't afford to let Greece fail without ruining their own banking systems.

And here is where our trades will come in.

2 ways to trade the Greek collapse

Last week I talked about how commercial property loans are rotting the balance sheets of a whole swathe of banks in the US at the moment. There are a few US banks that look especially badly exposed to this problem and I am currently sizing these up for a forthcoming Events Trader.

Equally, there are some European banks that are horribly exposed to the Greek debt crisis. Greece got into this mess in the first place because it needed to finance its deficit with foreign borrowing, like some Latin American countries did in the 1980s.

It is estimated that domestic banks hold around €40billion of the stuff. While over €200 billion is held abroad mostly by European banks who bought it and then presented it to the ECB to swap it for liquidity, in a game very similar to the idiot's carry trade.

This is the reason why Germany and other European countries ultimately decided to help Greece, not because of the euro stability but because an outright default will cause a second banking crisis in Europe with more banks potentially becoming insolvent.

That's why I'll be looking to short European banks using my spread betting account.

Who is worst exposed? I have two candidates so far. Credit Agricole in France (CA FP) could be vulnerable as it owns 82% of Greek bank, Emporiki. Another strong candidate is Societe Generale (GLE FP). It is estimated that French banks own more than €50bn of Greek debt. Both these banks could take a major hit under a restructuring plan.

However it's vital that you wait to see if a default occurs. These trades could be very profitable. But when politicians are involved, it is better to act after the event instead of trying to take a bet on what could happen. I will let you know as soon as I think it is time to short the right European bank.

Or course there will be more than one way to skin this cat. Another option is to buy Greek bonds.

Two year Greek bonds are currently trading around 90%, and at these prices I would stay away from them. Yes you can earn 25% in two years, but the risk of default is still too great to be taken even with the bailout agreed.

A better strategy is to wait and see if a default occurs, and then pile in. A defaulted bond will still be restructured - otherwise Greece will be locked out of the financial markets, and most holders will be forced to get out. This would be a disaster for Greece.

Again look at Argentina as an example, the defaulted bonds traded as low as 15-20 cent to the dollar and ended up after a few years swapped for 35cents.

In fact, I'm convinced that we are heading into maelstrom of crises that will throw up some fantastic trades over the next year. We are not going to see a return to the low volatility environment of 2003 to 2007. It will be back the great trading days of the 1990s I remember it fondly when every year brought a crisis, and another superb opportunity to make money if you know how.

For the moment, let's sit on the sideline and wait for the opportunity to get in on these two potential trades. If you would like to contact me, please drop me a message at eventstrader@moneyweek.com

Finally, just to note that we have triggered the stop loss on our Nokia trade and will have to tap out. I'll update on this next week.

Riccardo Marzi

Events Trader

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