Thursday, April 17, 2008

Iceland versus the hedge funds (Institutional Risk Analytics)

Spreads on credit default swaps for Icelandic banks currently trade in the 800-1,000bp range or more than 10x year-ago levels, but the volumes traded at these spread levels are thin, reflecting reluctance to buy protection at such levels. The sharp rise in CDS spreads for Iceland's three largest banks vastly exaggerate the economic situation, local observers tell The IRA.

Bankers and regulators in that country insist that, despite their tough macro picture, the junk level CDS spreads are the result of persecution by a vicious group of hedge funds; unregulated entities which are not afraid to evade securities laws, sometimes in multiple venues, to achieve their ends, the Icelanders complain. And the Icelanders blame the laziness of the global financial news media for not reporting both sides of this story.

Several Icelandic bankers tell The IRA that a handful of US and UK-based hedge funds, joined by Norway's State Oil Fund, are employing illiquid CDS markets to drive the apparent cost of funds for the three major banks to ridiculous levels - this in the hope of creating a liquidity crisis and perhaps even a national financial meltdown. Despite their common heritage, apparently there is no love between Norway and Iceland.

The Icelanders claim the hedge funds act in collusion and are conducting a concerted campaign of lies and vilification against their banks and the Icelandic economy. They cite repeated false statements made to the media about the financial condition of Iceland's commercial banks, attempts to suborn journalists and researchers into broadcasting these falsities, and threats of legal action by hedge fund employees against researchers and journalists who dare criticize these hedge funds by name.

So bold are these funds, say the Icelanders, that they even employ public relations firms to act as paid propagandists. Is this the brave new world of modern finance? Orchestrate a financial crisis then profit from it using cash settlement derivative gaming contracts? Perhaps it is no coincidence that these very same tactics were used by hedge funds during the partially successful bear raid against Bear, Stearns (NYSE:BSC). BSC, after all, did not actually default, depriving the hedge funds with long-CDS positions of the big payoff. Yet one reason that hedge funds are able to successfully attack victims like BSC or even an entire country like Iceland is the lack of liquidity and transparency in the OTC derivatives markets.

Icelandic banks are vulnerable to external market pressures due to the large percentage of liabilities not funded with core deposits, but unlike US banks, their balance sheets are unpolluted with highly leveraged structured assets, subprime loans and OTC derivatives. Given a choice between a short CDS position in say Kaupthing Bank, Iceland's largest, and JPM, we would take the former every time despite the huge difference in CDS spreads in favor of the later -- at the moment. Iceland's banks have none of the OTC market risk that weighs upon the top US names. Indeed, did you know that the largest US banks generated $2.6 billion in losses from CDS in Q3 2007 (latest data available from the OCC).

CDS spreads are more a function of speculative momentum than an indicator of default probability, thus the current wide spreads will soon attract investor attention. Since, in our view at least, the actual P(D) of the three major Icelandic banks is just about nil, in part because neither the Icelandic pension funds nor the central bank would ever allow them to default, enlightened investors able to write CDS on these names should be taking all of the bids available at current spread levels. The state pension system in Iceland is fully funded and around the same size as that of Norway's State Oil Fund on a per capita basis.

As we told the IFSA, the best way to deal with troublesome hedge funds wielding illiquid CDS is to bury them in same. To us, buy side investors who own Icelandic bank debt should start hitting bids in CDS and take advantage of the ridiculous spreads before they disappear.

1 comment:

Richard said...

I come to a different conclusion than that of the article: I believe that the CDS spreds on Island's banks are thin because few can afford them, except for a few British Isle and Cayman Island hedge funds, and because we don't know if the CDS insurance provisions are funded, and can be paid out, or really serve an real economic purpose; yet the spreads serve as a reliable indicator of the illliquid nature of Icelands banks' asset portfolio and the incapablity of the central bank to deal with a run on the deposits of the banks which would likely result in a freeze on the deposits many of whom are not only local citizens but British Investors who have deposited funds via Internet investing.