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.

While traditional retail investors lack access to many of the sophisticated tools, such as currency leverage and CDSs, which hedge funds can utilize to profit from crises, they should be equally aware of the opportunity and risk pervasive in markets. A ramp-up of the crisis in Europe could catalyze another stage of gridlock in markets. Emerging markets, including Brazil and China, are heavily dependent on European end-markets for their sales. Although emerging markets are continuing to decouple from the developed world, they are still more reliant on exports than they are on internal consumption, presenting both risk and safety.

On the one hand, resource-rich and debt-light China has a vested interest in maintaining stability in financial markets and assisting Western nations in their resumption of growth. On the other hand, should the eurozone crisis spread to the U.S., for example, whose national debt has doubled since the recession, instability could cause a massive sell-off in both debt and equity markets. Negotiations to extend our national debt ceiling before a looming August deadline are slow and contentious. Republicans want guaranteed spending cuts and entitlement reductions in exchange for their votes, but are fighting to avoid any tax hikes. Democrats want a revenue bump.

If the U.S. were unable to boost the ceiling hike by Aug. 2, it would result in technical default. With QE2, or the Federal Reserve's quantitative easing, also ending, it's no wonder that investors have exhibited a manic tendency in recent weeks. Several bullish researchers, including fixed-income analyst Jeffrey Rosenberg at Bank of America ( BAC), have expressed the view that technical default or missing one or several coupon payments would be an immaterial event. That view is purely speculative and JPMorgan ( JPM) has issued a contrary stance, warning that such a move in, by financial definition, risk-free instruments would roil markets and may catalyze another crisis.

A last minute compromise is almost certain. But, should Republicans opt for obstinacy, technical default is possible. As the debt situation has reached a tipping point, Democrats, who control the White House and Senate, have the most to lose in the event of a stalemate. Thus, it may benefit Republicans, though would punish the country, if technical default were to occur because it would be cited as leadership failure ahead of the upcoming presidential election.

One way to insure against a technical default would be by shorting Treasuries. Several ETFs offer short Treasury exposure and several offer exposure with leverage. Direxion now sells two unlevered short Treasury funds: the Daily 7-10 Year Treasury Bear ( TYNS) and the Daily 20-Year Plus Treasury Bear ( TYBS). These funds offer inverse exposure to Treasuries.

-- Written by Jake Lynch in Boston.

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