Free The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE by Faisal Islam Page A

implications for the debts of the Cypriot government and its banks. It seems impossible to trade this information like one might trade inflation numbers or currencies. We also ponder how the hedge funds based on algorithmic computer-trading cope with having to decode Angela Merkel’s glaring smile.
    In 2006 ‘The Big Short’ against American subprime mortgages made billions for the hedge-fund traders willing to take a negative view. By 2010–11 it was ‘The Epic Short’ – against the euro. The victims were not overextended financiers of exotic home loans, but the treasuries of proud Western nation-states. And the bet was again coming from the East Coast of the USA. Some of the same hedge funds that banked hundreds of millions of pounds from subprime were also in on these speculative attacks. But they were joined by more seasoned participants in sovereign-debt markets: the vulture funds that traditionally focused on Third World debt. I suggested to the principal of one vulture fund that the EU authorities were going to ban some forms of the trade. ‘Let them. We’ll just trade with counterparties in New York or Switzerland instead,’ he said.
    By 2011, shorting the single currency was proving recurrently profitable. To be clear, traders were not actually shorting the euro. The wisdom in the markets was that shorting the euro in currency markets was far too risky. What if Greece and the other crisis nations were kicked out of the Eurozone, and the euro basically became a twenty-first-century Deutschmark? No, the way to get at this trade most efficiently and with maximum leverage is via the famous credit default swaps market.
    The trader explains how the market and the trade works. Traders buy and sell protection against a bond defaulting for an annual fee measured in fractions of a per cent, or ‘basis points’. If I am worried about Greece defaulting, I buy protection, pay the fee, post some collateral, and no longer have to worry about a default. If Greece goes bust, the seller of the protection pays out in full the value of the bond, and then has to claim what scraps he can from the recovery process. Simple enough – in essence, it’s a form of insurance. If I want to play this as a speculative bet, rather than a service to hedge my default risks, this is also possible. It was being used perfectly legitimately to gain from the demise of the euro periphery. Here’s how to make your millions. Step 1: Buy CDS protection for, say, Greece defaulting when the risk was low, at say 300 basis points, or a 3 per cent premium. Step 2: Wait for some riots or an inconclusive election, which skyrockets the risk of Greece going bankrupt. Step 3: Sell the CDS contract back when the risk is high, the spread at 1000 basis points, or 10 per cent premium, at vast profit. Step 4: Repeat with other euro countries.
    ‘Even from a 100 basis points [1 per cent] move,’ a trader told me, ‘I could make $4 million profit from a trade that required $6 million cash collateral. To make that profit in the bond markets would have required $100 million cash.’
    Much hinged on the amount of collateral your counterparty required. For a small hedge fund, the figure would be high, for an investment bank low. For American International Group (AIG) as we shall see in Chapter 6 (see here ), it was, for a period, zero, which helped fuel the mania that would eventually fell it. Yes, this is the same famous CDS market that – through AIG Financial Products’ unbelievable trading activity in London – nearly threatened 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. ‘This is an enormous unregulated market,’ Soros told me, ‘45 trillion dollars, which is equal to the entire household wealth of the United States, five times the national debt, five times the capitalisation of the stock market. It’s an enormous