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European Debt Crisis: How to Profit No Matter What Happens

Currencies / Euro Jan 21, 2011 - 05:54 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleShah Gilani writes: Since the European debt crisis first emerged in early 2010, it has dominated headlines, roiled the world financial markets, and has kept investors in a perpetual state of alert as they wait for the next shoe to drop.

But let me share with you a little-known secret: Investors who understand where the "fault lines" are forming in this Eurozone debacle can transform the biggest sovereign-debt crisis in years into a major profit opportunity.

Let me explain...

Gone are the days when European countries were relatively insulated from their fiscally foundering cross-border neighbors. That's unfortunate since a number of European Union (EU) nations are experiencing economic and financial troubles right now - and since that list seems likely to get longer.

To protect - indeed, to save - the euro, EU members have to agree to maintain a united front. In other words, EU members that have embraced the European euro as the common currency for the entire community - aren't free to devalue themselves.

That's difficult on several fronts. With the member interdependence brought on the EU formation, the sad reality is that the sins of a few troubled members are very often paid for by the entire family. The member countries with the weak economies find it increasingly difficult to stay in the game, while their healthier counterparts become increasingly resentful of the economic and financial damage they are asked to incur.

So when the global capital markets punish profligate states by depreciating their sovereign debt, the fear of default is almost certain to infect nearby states - and even the community as a whole. That's because the uncertainty about the financial soundness of several EU members is undermining the euro.

Shades of Enron?

In order to stoke investor demand for the sovereign debt of EU member countries - and to provide badly needed liquidity - the European Financial Stability Facility (Fund) was created. The $520 billion (440 billion euro) rescue package had several mandates. It was designed to provide capital to buy bonds of issuing member states and to infuse capital directly into banks and financial intermediaries to ensure their continuing viability.

But there's a giant problem with the fund: It was structured as a "special purpose vehicle," or SPV, a type of venture that can be used to hide debt. SPVs, and the collateralized-debt obligations (CDO) they often housed became household names after the collapse of Enron Corp. and the onset of the global financial crisis.

A CDO has several "tranches," or layers, of securities that make up the whole structure. The top layer is usually rated "AAA," or investment grade, because the cash flow from lower-rated tranches is diverted to investors in the "AAA"-rated tranche, if necessary. Since there's only so much cash flow coming into the whole structure, investors in the lower-rated tranches are at risk of losing out if the money they expect to receive is diverted elsewhere.

Of course, investors in the lower-rated tranches get a higher yield for bearing more risk. If the underlying collateral of the CDO continues to support interest and principal payments for all tranches, the additional risk taken by some investors can pay off handsomely. But as we saw in the credit crisis, these structures can implode. Sometimes even investors in the "AAA"-rated securities end up with losses - or are even wiped out.

The European bailout fund is backed by the individual guarantees of all members. If a member fails to contribute its share of capital based on its guarantee to do so, all other members are required to pony up additional guarantees and capital, as needed.

And that's where the problem with the whole structure begins. As failing members tap into the fund, it's absurd to believe that those same countries can guarantee the fund they are drawing from with capital they don't have.

If other countries are then going to be called upon to make up for what a drawing member isn't able to contribute to the fund, that will only put that much more stress on other members. Some will opt to draw from the fund themselves - before it dries up, or before they are called upon to add to the fund at the same time they are being undermined by capital markets that recognize their financial vulnerability.

Yes, the top tranche of the fund is rated "AAA." That's why Japanese investors are offering to buy as much as 20% of the fund. It's also why China has indicated that it may want to buy the securities that the fund issues so that it may be capitalized.

But while outsiders buy up the "AAA"-rated tranches, European member states will be left to buy up the lesser-quality tranches. That puts Europe on the hook for the first financial hits the fund takes if faltering Eurozone members can't climb out of the holes they've dug for themselves.

It's a precarious position. Success depends on a perception that strong demand for securities issued by the bailout fund to capitalize weak links in the EU will be sufficient to underpin both the fund and the sovereign debt obligations of the issuing states.

How to Profit - No Matter Which Way the Euro Goes
Given that Greece and Ireland have needed to be rescued, it's clear that the bailout fund, as originally capitalized, is woefully inadequate. Talks are underway to raise the size of the fund. And with investors from Japan and China offering to buy the fund's securities, there's a good chance the size of the facility will be expanded.

While that would seem to be the kind of good news that would strengthen the euro, the reality is that this only partly true. Cause for concern also remains.

By understanding that this is a mixed bag, we're actually able to spot and refine a strategy that will let us invest in - and trade - the rise and the fall of the euro.

The investment vehicle that I like to use when positioning myself to play the rise and fall of the euro is the ProShares UltraShort Euro Exchange-Traded Fund (NYSE: EUO). UltraShort Euro is actually a leveraged, "inverse ETF." It is designed to correspond to twice the inverse of the daily movement of the U.S. dollar price of the euro. So if the euro is falling in value relative to the U.S. dollar, this ETF will rise in price.

Because a lot of investors believe that the euro is in trouble as some Eurozone countries teeter on default, the currency has been trending lower against the U.S. dollar. Big traders have been shorting the euro in currency markets.

Since talk of enlarging the bailout fund began a couple of weeks ago - and as talks come to a head this week - the perception that the fund will be expanded and better capitalized has caused the euro to rally. There has been a lot of short covering in the euro, which rose to a recent high of $1.3345 last Friday.

Perception could afford investors a short-term play in riding the rallying momentum in the euro. Since UltraShort Euro moves opposite the rallying euro, investors who short the ETF or who buy some near-month, at-the-money "put" options can play any continuing short covering and upward movement in the euro.

But if you are going to play the perception side of the euro's recent movement (that bailing out wobbly Eurozone members will strengthen the euro), make sure you have very tight "stops" on your positions, because at any moment perception could give way to reality.

For a longer-term play - one that, in my opinion, is more of an investment - I would position myself for the euro value's demise.

The reality behind the short-term perception that a bailout could strengthen the euro is that Europeans themselves don't want the euro to strengthen.

In a twisted irony, a rising euro undermines the desperately needed export business that European countries are counting on to dig themselves out of trouble. So while these countries want investors to buy their bailout-fund securities to support their finances, they are hoping the euro falls in value to make their exports cheaper on world markets.

If you want to see the deep game that's played in the world capital markets, consider this fascinating aside. Japan and especially China (the two powerhouses offering to buy the European-bailout fund's suspect securities) both want a stronger euro relative to their own currencies so that their goods will be cheaper than competing European goods on world markets. That's why these two Asian heavyweights are voicing support for Europe and its bailout.

Final Thoughts
The disjointed family that makes up a culturally and socially diverse European Union is plagued with structural problems that aren't going away any time soon.

In the race between illiquidity and insolvency, illiquidity will lose out in the short term. But insolvency stands a better chance of crossing the finish line.

And that's why I like buying UltraShort Euro, or buying calls on EUO. Taking a long position in this ETF is a bet that some European Union members might default, or some members could leave the EU. In the end, however, the euro will drop in value.

[Editor's Note: If you like the market insights and investment analysis that stories such as this one provide -but you want to receive stock recommendations, too, take a close look at our monthly affiliate newsletter, The Money Map Report.

Each month, the global-investing experts who write for Money Morning get together and identify the very best profit opportunities you'll find anywhere in the world. You read about many of those ideas in Money Morning. But the best ideas are reserved for The Money Map Report, or MMR.

New subscribers to MMR have a singular opportunity right now. We've just published our annual forecast issue, and it's available with a new subscription.

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