When a short beats a CDS

One of the primary motivators for the move towards and growth of credit default swap trading was the ease with which short trades could be conducted. No need to find a cash bond to borrow, no need to finance the short, and less chance of a short squeeze in case bonds in limited supply all of a sudden saw a surge in demand.

Well given what has happened in the the Greek CDS case and the CDS community’s ability to avert a credit event to trigger swap payments, it might appear that those extra costs may make up for some of the added benefits – at least in the sovereign space. It is clearly a controversial issue which some CDS buyers aliken to theft, but what so obviously is a trade that has worked in favour (and in theory) of the short-sellers (those who bought CDS protection against the Hellenic Republic earlier on) has turned into what could be a nighmare-ish scenario which leaves them continuing to pay for ‘bad protection’.

Enter David Einhorn, and several others like him who recognized this risk and problem before some of the ‘other guys’ and willingly paid up for the short in order to ensure he could profit when it came to closing time.

As summarized in Bloomberg,

Greenlight Capital Re Ltd. (GLRE), 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.”