Euro: If It's Broke, Don't Fix It?

04/28/2010 05:12 am ET | Updated May 25, 2011

Here's the deal. Hedge funds are betting the Euro will crash against major currencies. The "short-Euro" trade, however lucrative to the gods of Greenwich, raises three scary questions with one thing in common:

Nobody knows the answers.

1. What happens when money exploits problems instead of fixing them?

The Wall Street Journal describes the economics of a bear Euro bet as follows:

The euro, which traded at $1.51 in December, now trades around $1.35. With traders using leverage -- often borrowing 20 times the size of their bet, accentuating gains and losses -- a euro move to $1 could represent a career trade. If investors put up $5 million to make a $100 million trade, a 5% price move in the right direction doubles their initial investment.

The Euro is weak, in part, because of the financial crisis in Greece. Investors are hesitant to refinance the country's debt, which makes sense on one level. Who wants to buy a bad bond? But the incentives are out of whack, when money flows into misery bets that turn "long-term value" into an oxymoron.

2. What happens when empty creditors create an endless supply of problems?

Credit default swaps enable investors to buy and sell credit risk. The securities sound like clever financial tools. But said another way, they enable financiers to originate bad loans and then trade out of the problem. Credit default swaps gained notoriety at AIG, and now these weapons of money destruction keep appearing in connection to Greece:

The threat of ratings reversals, a downgrade of Greek banks by Fitch, and strikes that shut down most of Athens on Wednesday have precipitated another spike in the price of Greek credit default swaps, which investors buy as insurance against default. Investors are now demanding a risk premium of 392 basis points, the most in two weeks. That means someone who holds Greek debt would have to pay $392,000 to insure $10 million in debt against default for a year.

3. What happens when hedge funds attack in packs?

Money managers signal their moves at dinners, conferences, and through warnings from guys like George Soros that "the Euro may fall apart." Big money chases good ideas, right? But what happens when smart money turns destructive? Wall Street 101, if you'll excuse the vernacular, is to attack the weak sister. Short Euro or short Greece -- nobody can project the unintended consequences when there's massive firepower behind the assault.

Personally, I think credit default swaps have to go. What do you think?

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