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December 12th, 2011

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An American hedge fund is placing bets that Denmark is headed for an Iceland- or Ireland-style economic collapse.

The New York-based Luxor Capital investment fund has been short-selling Danish credit default swaps (CDS), on the presumption that Danske Bank, DenmarkÂ’s largest, is too heavily leveraged and too big to save.

The theory goes that if the euro crisis deepens or the Danish housing market declines – two possibilities that many experts are beginning to consider inevitabilities – Danske Bank could go belly-up, and Denmark would not have the reserves to bail out its flagship.

“Luxor’s analysis is based partly on the fact that Danish households have relatively high debt, and partly on the fact that Danish banks are really dependent on foreign funding,” Copenhagen Business School (CBS) economics professor Finn Østrup told Politiken newspaper.

“Those considerations are totally correct and well-known in the Danish debate – but the new part is that foreigners are now noticing it,” Østrup said. “It shows that Denmark is certainly not immune to the debt crisis.”

“Investors are looking for the weak spots everywhere, and now they’ve found Denmark’s. There’s no natural law that says Denmark will continue to be a safe haven for investors,” he added.

Luxor is gambling that even though the Danish economy may look relatively solid right now, both banks and citizens alike have stretched their economies so thin that another drop in the housing market will push them over the edge into insolvency.

The American investment firm is therefore short-selling Danish CDS, a type of insurance against a state bankruptcy, with the expectation that it will soon have the chance to sell them back at much higher prices, assuming the euro crisis and domestic housing market worsen.

CBS professor David Lando noted that if other investors see sense in Luxor’s gamble – or if they simply jump on the bandwagon – the result could be a devastating, self-fulfilling prophecy.

“It could easily happen that a buy-up of credit default swaps on Danish government bonds could send the signal to other investors that there’s something wrong with the Danish economy. In that way, the credit default swap market can carry those ideas over into other markets,” Lando told Politiken.

Østrup added that Luxor’s analysis was grounded in presumptions that were highly possible.

“The Danish state has a relatively low debt, but that could change if the government is forced to cover other debts in a situation where, for example, Nykredit or Danske Bank were to go bankrupt. Luxor is completely right that the Danish banks’ assets are huge in comparison to the Danish GDP.”

In its Q3 investor newsletter, Luxor estimated the Danish banksÂ’ assets at 454 percent of GDP.

By comparison, that ratio is on par with Germany’s, and far below that of Switzerland or the UK – let alone Iceland and Ireland’s astronomical debt to GDP imbalances. But it is also double the figure for the US, according to Forbes.

Spokesmen for Danske Bank maintained that LuxorÂ’s analysis of the bankÂ’s risk level was wrong and that Danske BankÂ’s investments posed no problem for either the bank itself or Denmark.