Bloomberg reported today that, back in July, David Einhorn and some other people decided that (1) betting against European sovereign debt was, and would remain, a good idea, but (2) doing it in CDS form was kind of dumb, so (3) they’d switch to doing it in physical form, by borrowing and shorting the debt. Here’s what Einhorn had to say in his July investor letter:

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.

Let’s talk about that first reason for a minute because I think it’s sort of illuminating. The problem is that Europe was in July, and is now, and wow that’s depressing, trying to cobble together a “voluntary” debt exchange where holders of Greek debt happily hand it in to Greece and get back a thing with a 50% face value haircut that is also a piece of crap. If you’re a European bank who owns Greek bonds and CDS to hedge them, and you feel pressured to accept that deal, then you feel like the “insurance” you bought on your bonds should “pay out,” I suppose, though that’s all fairly hypothetical. If on the other hand you’re David Einhorn and you bought CDS and then Greece haircuts its debt, you feel like your bet against Greek debt has been vindicated so it should pay out. But it doesn’t, says ISDA, because the exchange was voluntary and there was no “credit event” under the rules governing your CDS.

Now you can feel some feelings about this – you can think it means the end of the CDS market, or that it’s no big deal; you can think that ISDA’s determination that this “voluntary” exchange is not a credit event is clearly right, or that it’s an evil conspiracy; and of course you can have a range of views about the likelihood of the voluntary exchange happening and about whether, after the voluntary exchange, any un-exchanged bonds will be paid at par or forcibly defaulted.

But you can avoid all that and just short the bonds, which seems to be what Einhorn did. Here Einhorn goes to his prime broker, borrows some Greek bonds, and sells them. In six months, when the bad thing has happened, he buys them back for cheap and returns them to the dealer. That is all straightforward. What could be easier.

Well, you might wonder what happens if, I don’t know, the bonds that he borrows are transformed into something else. This might be relevant to you if you are borrowing Greek bonds, which everyone expects to be transformed into something else. (Specifically smaller, crappier Greek bonds.) Securities lending agreements typically provide for this in the expected way – you don’t return the securities you borrow, you return “equivalent securities,” and

If and to the extent that such Loaned Securities … consists of Securities that are partly paid or have been converted, subdivided, consolidated, made the subject of a takeover, rights of pre-emption, rights to receive securities or a certificate which may at a future date be exchanged for Securities, the expression shall include such Securities or other assets to which Lender or Borrower (as the case may be) is entitled following the occurrence of the relevant event. … In the event that such Loaned Securities … have been redeemed, are partly paid, are the subject of a capitalisation issue or are subject to an event similar to any of the foregoing events described in this paragraph, [long-winded but entirely reasonable things happen].

So, fine, if Greek bonds transform into other Greek bonds, Einhorn returns the other Greek bonds.

But … they don’t. Under the voluntary regime anyway. There, nothing has transformed into anything – some people have just agreed to do a trade. Einhorn’s obligation remains what it was – to deliver back the Greek bonds he borrowed, not the ones that those bonds could have been exchanged for.* It is hard to imagine him saying to a securities lender “oh, hey, yeah, I exchanged your bonds for you, hope you like these smaller crappier bonds.” He just doesn’t get to do that with the lender’s bonds. And if he tried – well, I think his prime broker would be a lot more conflicted than the ISDA determinations committee.

You can if you like imagine how this impacts the trade. Einhorn borrows bonds and shorts them. Greece deteriorates and voluntary plan gets uglier, so they drop in value. He has a mark-to-market gain. Voluntary plan is executed. Some bonds are gone. Others remain. When Einhorn wants to close out the position, he has to go buy in those remaining bonds. Their price will depend on whether people now expect them to hard default, or to be paid off, plus I guess on their post-exchange scarcity and how crowded this trade was. If a hard default is likely, or occurs, the short seller makes lots of money. If the stub of bonds not voluntarily exchanged are expected to be paid at par, the short seller loses money.

These are exactly the cash flows you’d get from buying Greek CDS.

None of this happens of course – David Einhorn doesn’t enter into a term borrow of bonds, short them, forget all about them, and return a year later to scramble to buy back those bonds. An actual short seller would buy in the bonds and close out his short just before the voluntary exchange, when they’re cheap, and even if he didn’t want to his borrow would likely be called in by his prime broker who is, after all, a big bank who feels pressured to participate in the voluntary exchange.

But everything is just the present value of the thing it will eventually be, so this should cast a shadow over current trading levels – if post-exchange bonds are gonna do great, then the bonds should trade above their exchange value. (If not, not.) And the equivalency is worth keeping in mind when you see people freaking out about how broken CDS is. (Sometimes. None of this has anything to do with Einhorn’s other reason for moving to physical, which is the contagion risk of the banks who write the CDS maybe having written too much of it. That is a whole nother kettle of fish.) CDS levels should more or less track bond yields because they should more or less replicate the experience of short selling bonds – and it’s harder to disconnect the two than you might at first think.

Einhorn Trades Swaps for Shorts When Betting on Sovereign Debt [Bloomberg]

* Technically section 6.7 of the standard securities lending agreement provides that on corporate events that require an election, the lender should be able to make the election – so if this falls under that category the prime broker could tell Einhorn whether they want the original bonds or exchange bonds back. It’s not at all clear that it does fall under that category, and in any case you’d expect them to elect the original bonds.

34 comments (hidden to protect delicate sensibilities)
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Comments (34)

  1. Posted by DingALing | December 16, 2011 at 1:33 PM

    The only thing one can really swap for anything Greek is their dignity as Greek is in short abundance of that among many, many other things.

  2. Posted by guest | December 16, 2011 at 1:40 PM

    There is no way these European Sovereign debts will default.

    All in !!

    – J Corzine

  3. Posted by Chevy_Chased | December 16, 2011 at 1:47 PM

    Actually an interesting article about something other than the moral implications of what does/does not constitute insider trading. I can't help thinking that when Matt is typing/editing/scanning the comments of his articles that he has the same expression as the picture of Einhorn above. In a more perfect world I like to think that Matt wears the same backwards baseball cap and children's handprint baby blue sweater.

  4. Posted by guest | December 16, 2011 at 1:50 PM

    I picture Matt as more of a skinny jeans and lumberjack shirt guy.

  5. Posted by Lenny D | December 16, 2011 at 1:52 PM

    "whole nother kettle of fish" Really Mat???

  6. Posted by ohh herrooo | December 16, 2011 at 1:52 PM

    Mr. Levine, what you've just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.

  7. Posted by guest | December 16, 2011 at 1:55 PM

    You're an idiot.

  8. Posted by Guest | December 16, 2011 at 2:03 PM

    You're wrong guest! Matt is everything that is man. He has a barrel chest and python arms. He can crush a bowling ball with his thighs and throw a football a mile. He drives the ball over 400 yards and is the best volleyball player on the beach at a given time. He can ride a unicycle. He's really smart and makes sure others know he's smart. He sleeps in Levi jeans with a Chicago Bulls hat on. He's the incarnation of all Clive Cussler protagonists. He eats oatmeal for breakfast every goddamn morning. His favorite show is Salute Your Shorts. He can't stand the smell of freshly baked cookies. He likes to read and talk about really boring shit because he has such a powerful imagination that if he read normal stuff his head would explode. He also like to put blueberries in his oatmeal. He sucks at Mario Kart.

    That's how I picture Matt

  9. Posted by lost puppy | December 16, 2011 at 2:04 PM

    It takes a certain kind of loser to be the one that officially plays out an otherwise hilarious quote.

  10. Posted by Madison Euro LP | December 16, 2011 at 2:20 PM

    I hope someone leaves a flaming bag of Greek bonds on your doorstep, and I bet you would call the Greek bonds poop.

  11. Posted by Homer Simpson | December 16, 2011 at 2:22 PM

    Went by the name of Matt. Seven feet tall he was, with arms like tree trunks. His eyes were like steel: cold, hard. Had a shock of hair, red, like the fires of Hell.

  12. Posted by geoffgeoffgeoff | December 16, 2011 at 2:33 PM

    I was with you on everything until you got to Mario Kart. True renaissance men know a thing or four about beating Rainbow Road using Princess or Yoshi.

  13. Posted by Writing Quant | December 16, 2011 at 2:50 PM

    Matt, as much as I want to read some of the shit you write, I just can't. You write like a complete asshole. Quit blabbering on for 20 paragraphs when it can be synthesized into two or three.

  14. Posted by NYRB Seller | December 16, 2011 at 2:54 PM

    Actually, to the extent the account that is lending bonds to the repo desk from who you are borrowing said bonds wants to go into the exchange, you can do a short-tender. Lender of the bond agrees that the repo desk will "tender on his behalf" and the borrower of the bonds agrees to return to the repo desk at the end-date of the repo the proceeds of the exchange. I've done this a bunch of times over the years. You can't be sure the repo desk can accomodate you, but typically they do. The repo desk typically has a few guys who have done term repos that go over a tender deadline and those guys are desperate not to get left out.

  15. Posted by Ranting Slosher | December 16, 2011 at 2:59 PM

    After your description, I believe I have seen Matt at Minetta's looking feverishly for someone.

  16. Posted by Guest | December 16, 2011 at 2:59 PM

    Patience all. Matt's writings are like carbon atoms freely floating around the blogosphere, they just need to be brought together under high pressure, and in time they will transform into diamonds.

    –Matt's 7th grade English teacher

  17. Posted by E. Texas Gas Trader | December 16, 2011 at 3:00 PM

    You must be a Chesapeake natgas price forecaster.

  18. Posted by Guest | December 16, 2011 at 3:08 PM

    No, but I play one on the conference calls.

    -A. McClendon

  19. Posted by Dr_Zaius | December 16, 2011 at 3:11 PM

    You can't read?

  20. Posted by InfiniteGuest | December 16, 2011 at 3:15 PM

    It's actually kinda cool. You can negotiate practically anything, and sometimes even just kind of do stuff in the moment that you never agreed to pay for, and it goes by without much argument.

  21. Posted by Guest | December 16, 2011 at 3:18 PM

    I'm really confused

  22. Posted by Guest | December 16, 2011 at 3:38 PM

    Feverishly or furiously?

  23. Posted by geoffgeoffgeoff | December 16, 2011 at 3:46 PM

    In a cup?

    -One-Armed Typer

  24. Posted by Guest | December 16, 2011 at 3:56 PM

    you forgot Matt kicked Chuck Norris' ass once, in a movie.

  25. Posted by Guest | December 16, 2011 at 4:26 PM

    "everything is just the present value of the thing it will eventually be" really should have been a tag.

  26. Posted by dad | December 16, 2011 at 5:06 PM

    painful

  27. Posted by ADD Quant | December 16, 2011 at 5:35 PM

    My mind starts to wonder after about 21 words of Matt's blabbering…

  28. Posted by Peter Pete | December 16, 2011 at 11:21 PM

    What is short selling?

    UBS MD

  29. Posted by lenny | December 18, 2011 at 7:44 PM

    percentage of comments that address substantive content of matt's posts: 8%
    percentage of comments that address length / style / douchiness / and general uncoolness of matt's posts: 97%

    — math genius desiring that matt design a chart and write a really long blog post analyzing the above

  30. Posted by Guest | December 19, 2011 at 8:41 AM

    My mind wonders what kind of retard doesn't know the difference between wander and wonder.

  31. Posted by Bill | December 19, 2011 at 9:26 AM

    They use his foreskin as a tarp when it rains at Yankee Stadium

  32. Posted by kid who agrees | December 20, 2011 at 2:38 PM

    :D

  33. Posted by Bristol Airport Hotels | April 19, 2012 at 3:18 AM

    LLSZKa Thank you ever so for you blog post. Awesome.

  34. Posted by bookmarking submission | September 11, 2012 at 2:32 AM

    Aw5uiU Thanks so much for the blog post.Much thanks again. Great.