The Rise Of Activist Sovereign Hedge Funds, The "Subordination" Spectre, And The Real "Coercive" Restructuring Threat

When Zero Hedge correctly predicted the imminent rise of the "activist sovereign hedge fund" phenomenon first back in June 2011 (also predicting that the "the drama is about to get very, very real") few listened... except of course the hedge funds, such as Saba, York, Marathon, and others, which realized the unprecedented upside potential in such "nuisance value", long known to all distressed debt investors who procure hold out stakes, and quietly built up blocking positions in European sovereign bonds at sub-liquidation prices. Based on a just released IFRE report, the bulk of this buying occurred in Q4, when banks were dumping positions, promptly vacuumed up by hedge funds. More importantly, we learn from IFRE's post mortem of what is only now being comprehended by the market as having happened, is the realization that the terms "voluntary" and "collective action clauses" end up having the same impact as a retailer (Sears) warning about liquidity (and the result being the start of the death clock, with such catalysts as CIT pulling vendor financing only reinforcing this) to get the vultures circling and picking up the pieces that nobody else desires. As a reminder, it was again back in June we predicted that "the key phrase (or two) in the proposed package: "Voluntary" and "Collective Action Clauses"." Why? Because what this does is unleash the prospect of yet another word, which is about to become one of the most overused in the dilettante financial journalist's lingo: "subordination" or the tranching of an existing equal class of bonds (pari passu) into two distinct subsets, trading at different prices, and possessing different investor protections (we use the term very loosely) with the result being an even greater demand destruction for sovereign paper.

Incidentally this is precisely the reason why we predicted the second Greek bailout would be dead back in June of last year (proven right) as it underscores a very specific dynamic in bond trading, and thus demand, which apparently nobody in Europe grasped at the time, except for the hedge funds who now control the entire process and can demand anything to keep the Eurozone from falling apart. Unfortunately, it is now likely too late - with everyone finally figuring out what subordination means, and the S&P making it the highlight of their downgrade FAQ, the fear of future subordination alone is why demand for peripherals will likely plunge even more, paradoxically allowing activist funds to build up even bigger blocking stakes at cheaper price, throwing Europe into a toxic loop where courtesy of its stupidity it will now have to pay fund managers, the same ones it vilified, billions and billions, so they don't pull the plug on Europe.

IFRE describes when the realization of "nuisance value" set in:

One head of rates trading at a major dealer noted several instances in the fourth quarter when second-tier European banks looked to sell portfolios of Greek government bonds in the €50m to €100m range, with one trade reportedly even exceeding this.


While playing down the likelihood of all of these trades closing, the rates trader noted leveraged accounts had succeeded in building up large holdings of Greek government bonds recently.


“We saw probably five big transactions in the fourth quarter, and some of them definitely closed because some hedge funds have been able to build reasonable positions [in GGBs] of a few hundred million. You cannot [build a decent position] by buying €1m pieces,” he said.

Blocking stakes defined:

If one party managed to accumulate between a quarter and a third of a given series it might be able to block a debt exchange, making it likely that investors would focus on particular bond maturities. Foreign-denominated Greek debt that is subject to English law is also thought to be particularly targeted by vulture funds.

Finally here is IFRE's 7 month delayed analysis of what Zero Hedge readers knew in the first half of 2011.

Further uncertainty has been added by what the European Central Bank, the third member of the Troika, plans to do with its estimated €40bn of Greek bonds picked up under the Securities and Markets Programme since June 2010.


This makes it the largest holder of Greek bonds. However, President Mario Draghi reiterated that it was not a party to the current negotiations between Greece and its private creditors.


If the take-up of the bond offer is unsuccessful and a deeper, more coercive restructuring is required, using retrospectively introduced collective action clauses, the ECB will face a dilemma.


If it continues to hold out, it will subordinate all other holders who will see their Greek holdings in effect wiped out. But this would have other consequences. Many are European banks that would have their capital compromised and so need to be supported by the ECB. It would also make the institution’s holdings in other sovereigns, namely Italy and Spain, senior too.


“If collective action clauses aren’t binding on the ECB it’s hard to see how they could be binding on others,” said the hedge fund manager. “If bonds bought by the ECB are de facto senior, it turns the SMP into a double-edged sword. For every Italian bond the ECB buys, that could be less Italian debt servicing power for everyone else.”

Which is what the real threat of a coercive Greek default is: not the triggering of Greek CDS - that event will have no actual cash flow impact whatsoever. What it will have an impact on, is the waterfall bifurcation of all sovereign debt bonds into a universe of "covenant-stripped" bonds, all of which will have special treatment with the ECB, with Repoclear for repo pledging purposes. Most importantly, it will further collapse bond demand as investors will no longer know if the bond they purchase will be the same bond tomorrow, or some metamorphozed monster trading at pennies on the dollar because of some hedge fund's activitist strategy.