Hedge Funds Betting Against the Eurozone: Why You Should Worry

The 'Europe' sculpture of Belgian artist May Claerhout showing a woman holding up the symbol of the Euro stands outside the European Parliament building on November 17, 2011 in Brussels, Belgium.
The 'Europe' sculpture of Belgian artist May Claerhout showing a woman holding up the symbol of the Euro stands outside the European Parliament building on November 17, 2011 in Brussels, Belgium.

Some of the world's most prominent hedge fund managers are betting against the eurozone -- and not just the peripheral countries everyone knows are in trouble. They're taking positions against the core countries, economies that -- until now -- everyone has assumed were rock-solid.

Here's a primer on the world of hedge funds and why the latest developments in the recently resurgent eurozone crisis are yet another warning shot across America's economic bow.

How the Other Percent Invests

Put simply, hedge funds are investment funds for the wealthy. You and I put our money into mutual funds, which a fund manager watches over, moving investor money into and out of a portfolio of stocks, bonds, and other investment vehicles as he or she sees fit in order to maximize the fund's return.

Hedge funds are private investment funds that are typically open only to a limited number of investors and require a large minimum investment to participate.

Hedge fund managers use a range of advanced investment strategies to maximize investor return, including leveraged, derivative, and long positions, as well as what are known as "short" positions. "Going short" means betting that a stock, security, or other investment vehicle is going to decrease in value, rather than go up. "Going long," or betting an investment will increase in value, is the much more commonly taken position.

Say It Ain't So, Angela

Most of us know the big names in the eurozone that have gotten into serious financial trouble over the last few years.

  • Ireland had to be rescued by other eurozone members when its debt-fueled property bubble collapsed, pushing the country to the verge of sovereign bankruptcy.

  • Greece also had to be bailed out (twice) when it's sovereign-debt bubble burst, leaving it a hair's breadth away from default.

  • Spain is most recently in the news, as its own debt-fueled property bubble and fiscal problems are sending the cost of its debt to near-unsustainable levels.

  • Even France has been looked at suspiciously by the bond markets for a while.

But Financial Times is reporting that a group of hedge fund managers are now shorting some of the core countries in the eurozone, including Germany and the Netherlands, even though bond yields in those countries -- the gauge for measuring a country's fiscal and financial health -- are still at record or near-record lows.

In a nutshell, some of the world's best-paid, most-seasoned, and savviest investors are sufficiently convinced of the underlying sickness of even the most apparently stable eurozone countries that they're placing serious bets on their potential collapse. John Paulson, the billionaire who made his name (and his money) by shorting the U.S. mortgage securities market in the run up to the 2008 financial meltdown, is one of the hedge fund managers reported to be shorting Germany.

Who Rescues the Rescuer?

The financial crisis, which began here in the U.S., may still be roiling across the Atlantic.

Europe is sick. The U.K. has just slipped back into recession. Spain has, too, along with recently suffering another downgrade on its sovereign debt by ratings agency Standard & Poor's, which sent its bond yields back above 6% -- the danger zone. While the U.S. unemployment rate is still above 8%, it appears to be coming down. And while GDP growth of 2.2% is nothing to write home about, the U.S. economy is growing.

But Europe and America are inextricably linked. To a great extent, as goes Europe, so goes the U.S. American banks still have an undetermined amount of exposure to eurozone banks. The potential economic debt-market shock waves produced by the default of any of the larger European countries could send the American economy back into recession.

This is why the thought of Germany's economy going south is truly terrifying. Germany is the eurozone's biggest economy and, along with France, has orchestrated and made the biggest contributions to the above-mentioned rescues.

But who comes to the rescue when the rescuer needs rescuing?