The Greece-will-default trade may have run its course, as Europe's politicians and officials face the stark consequences if Athens fails to pay on its debt.

By Katie Benner
June 21, 2011

FORTUNE — A Greek default is being treated like an inevitability in the market, with the cost of insuring against such an event soaring to record levels. This is due, as we well know, to the fact that European finance ministers denied Greece a final installment of bailout money until it enacts an austerity plan, and that Prime Minister George Papandreou now faces a vote of confidence on his package of cost cutting measures.

But one of the big lessons of the 2008 financial crisis is that the rational market is no match for a group of determined government mandarins who will prop things up once they realize how high the stakes are. For example, the Lehman Brothers collapse vindicated hedge fund manager David Einhorn’s claim that the bank had hidden losses, had taken on too much leverage, and that the combination would result in disaster. Other financial firms had the same problems, and it stood to reason that the credit crisis would wipe their earnings away and make them prime targets for nationalization.

Short sellers circled these sickly companies, not realizing that Lehman had also created a paradigm shift with regard to the way politicians thought of big financial institutions. Officials made it clear that they couldn’t handle the chaos unleashed by Lehman’s bankruptcy and that there would be no more collapses. Government became the biggest, baddest market force around, but many players continued to bet against the banking system. The hedge fund manager who emerged as the winner post-2008 was David Tepper, who believed Washington, DC when it said that it was going to support Wall Street. Tepper bought companies that were weak, troubled, and systemically important, including Citigroup C and Bank of America BAC . For his troubles, he nabbed a $7.5 billion payday.

Greece, one might wager, will play out in similar fashion. Can we say with certitude that Greece doesn’t have enough money to pay its debts? Yes. Are we sure that Greece will never, truly, grow its economy fast enough to pay off the bill? Of course. But can we say that Europe’s most powerful finance ministers will let the country default at this very precarious time for the financial health of the European Union? I doubt it.

As Jamie Dinan, the founder of York Capital, told CNBC this May, it is now obvious that the Eurozone is “determined to keep the euro in tact, and they will bail out Greece.” A Greek default at this time, with interest rates and CDS prices leaping, would prove calamitous. The ensuing chaos would give the market an opportunity to hammer other weak Eurozone countries like Spain and Portugal. And a default in the current environment would give French and German banks no time to come up with plans to salvage their own hides, larded up as they are with Greek debt. While it’s true that Greece’s obligations will eventually need to be restructured and that the euro itself may also need to change, now is absolutely the worst time to make those moves.

“Everyone in the fund community bought CDS on Greece assuming that there would be a default,” says Chris Whalen, a banking analyst with Institutional Risk Analytics. “The guys still holding those positions will get stuffed because politicians have decided that we can’t find out whether the Europe’s big banks can withstand a default. And the amount of credit swaps is so big that no one wants to test whether those counterparties can all pay in the event of a default.”

You can find indications that some hedge fund managers have started to exit the Greece-will-default trade if you dig deeper into that soaring credit default swap phenomenon. (I say hedge fund managers because most CDS counterparties are hedge funds and banks). A CDS is just a contract between a buyer, who pays a premium, and a seller, who will make a payment to the buyer if a bond default occurs. One way for buyers and sellers to get out of these contracts is to sell their respective halves of the contract. Another way is to simply take out an offsetting CDS. For example, the buyer becomes a seller in a new contract, agreeing to make a payout in case of default and receiving a premium if no disaster strikes.

So while prices for CDS insuring against a Greek default have risen and the overall number of contracts has increased, the actual outstanding value of those contracts has been declining. That means that if everyone who owned a CDS on Greek debt settled their contracts tomorrow, a shrinking amount of money would change hands than the face value of all the contracts. That implies that more CDS are being written in order to offset existing CDS positions, and that less money will change hands in case of a default.

For those people who are actually jumping into the fray and buying CDS at the astronomical cost of $2.8 million a year, one must wonder who has enough cash lying around to wager that much money on an event that may not happen within the five-year life of the contract (or, if politicians have their way, at all.)

This is not to say that it’s impossible for those souls who have gone long a Greek default at this late date to come out winners. Default could sneak by the politicians working so clumsily to prevent it from happening. Fitch Ratings said that any rollover or debt exchange would still be considered a default, which constrains finance ministers and bond holders as they try to hammer out a rescue. And some traders have expressed a fear that there will be a “default by mistake” given the number of parties necessary to keep funds flowing into Greece and the complexity of the situation.

But it will take a miracle for market forces to win out over political fear. If we couldn’t take the pain in the US, why would Europe go down that road?

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