NEW YORK (MarketWatch) — Greenlight Capital is betting on the possibility of a major currency collapse and a surge in interest rates, the hedge-fund firm’s manager David Einhorn said Monday, citing ballooning government deficits in some of the world’s most developed countries.

Einhorn, who warned about Lehman Brothers’ frailty before it collapsed last year, also said financial institutions that are deemed as “too big to fail,” such as Citigroup Inc. , should be broken up.

Greenlight has been buying physical gold this year because Einhorn is concerned that efforts to save the financial system and fuel economic recovery are undermining the value of such currencies as the U.S. dollar.

On Monday, he said Greenlight has added new trades to this investment theme, buying long-dated options on much higher interest rates in Japan and other developed regions — effectively giving the firm the chance to make big profits from a jump in rates. The options, bought from major banks, are tied to interest rates four to five years out, Einhorn noted.

“Japan may already be past the point of no return,” he said during a presentation at the Value Investing Congress in New York.

Japan’s debt is equal to 190% of the country’s gross domestic product and its government deficit will be 10% of GDP this year, according to Einhorn.

Japan has been able to borrow money at roughly 2% a year to finance these deficits, partly because the country has many savers willing to buy low-yielding government bonds. However, some of these savers may begin spending instead as they enter retirement, Einhorn argued.

“When the market refuses to refinance at cheap rates, problems emerge,” he said, adding that this could trigger a “currency death spiral.”

Interest rates have been very stable in Japan for years, so the options on higher rates that Greenlight bought were relatively cheap. Einhorn said the “asymmetry” of that trade was interesting: If rates were to jump suddenly in Japan, Greenlight stands to make “multiples” on its positions.

“There remains a possibility that I’m wrong, and I hope I am,” he commented. But earlier in the speech he remarked: “Just because something hasn’t happened before, that doesn’t mean it won’t.”

Remedy to shore up system

Einhorn also compared potential problems in sovereign-debt markets to the financial crisis that engulfed markets last year.

When Lehman collapsed, investors reacted by dramatically increasing the cost of borrowing for rival Wall Street firms to the point where their business models were threatened, he Einhorn. The collapse of any major currency could have same impact of rerating the cost of financing governments in deficit.

Unlike Japan, the United States isn’t past the point of no return, the fund manager stressed. However, he criticized financial-reform proposals pushed by Treasury Secretary Timothy Geithner, arguing they provide a government backstop for the largest institutions, entrenching them further.

No institution should be too big to fail, Einhorn contended. “The real solution is to break up anything that fails that test. Lehman shouldn’t have existed in any size to threaten the financial system.”

The same applies to Citigroup and Bear Stearns, which J.P. Mortgage Chase & Co. acquired, as well as American International Group Inc. and “dozens” of other firms, he said.