How to Profit from U.S., Europe Debt Crises

BOSTON (TheStreet) -- The European debt crisis is taking center stage in the U.S.

Jean- Claude Trichet

Now, more than three years after the subprime debacle, other financial excesses are again threatening the global economy. Just last week, Greece received its second major bailout package, though it will be expected to implement further austerity measures to receive funds.

Despite accounting for just 2% of the eurozone economy, Greece could cause a contagion, meaning that if the country defaults on its debt, investors will lose confidence in the euro and other euro-zone debt, escalating bond yields, making borrowing excessively costly and, perhaps, leading to outright default.

From 1993 to the present, Greece's debt load has exceeded its annual GDP, a troubling statistic. In efforts to improve employment and bolster growth, Greece vastly expanded its public sector, elevating prosperity at the cost of long-run fiscal health. Similarly, Portugal, Spain and Italy engaged in reckless borrowing. Last week, Portugal's debt was downgraded to junk status by Moody's (MCO). Hedge funds, many of which were already profiting from European woes, smell blood in the water. One way to profit from default fears is by purchasing CDSs, or credit default swaps, insurance contracts on bonds. As fear swells, CDSs rally.

Other investment strategies include shorting the stocks of companies in the eurozone with significant exposure to the peripheral countries. For example, shorting the banks may still be a relevant technique, though dogs like National Bank of Greece (NBG) and Allied Irish Banks (AIB) have already plummeted to all-time lows on investor fears. They may have farther to fall as the crisis intensifies. It now seems almost inevitable that a large-scale financial restructuring will occur. Three years into the so-called recovery, sovereign debt issues continue to worsen as a tepid expansion has offered no tax revenue boon.

Other candidates for shorting include ETFs, or exchange traded funds, that offer direct sovereign exposure. For example, iShares MSCI Spain Index Fund (EWP) and iShares MSCI Italy Fund (EWI), deserve consideration. Last month, George Soros, considered among the savviest macro investors, warned that "we are on the verge of an economic collapse which starts, let's say, in Greece, but it could easily spread. The financial system remains extremely vulnerable." Soros made more than a billion in 1992 by shorting the British pound sterling and has written several books, prognosticating financial crises.

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