What Does Germany's Credit-Default-Swap Ban Mean for You?

[Editor's Note: Germany's credit-default-swap ban could be the first salvo in a new, global regulatory war. Here are three moves to make to protect your investments.]

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Germany did something on Tuesday that I've been hoping would happen for three years: It outlawed naked short-selling and speculation on European government bonds with naked credit default swaps.

The financial institutions that have been profiting from this type of speculation immediately went on the offensive.

German officials justified the surprise, unilateral move by financial regulator BaFin by stating that the "exceptional volatility" in government debt – if accompanied by massive short-selling and naked CDS trading – could result in excessive price movements that would actually "endanger the stability of the entire financial system."

Wall Street Responds

To hear Wall Street's reaction, you'd think that Germany was hiding something "that the market's not aware of," said Michael O'Rourke, managing director and chief market strategist at BTIG LLC, an institutional trade services provider, told Bloomberg News.

And Mark Grant, managing director of Southwest Securities, said Germany's actions make it clear the European stalwart is engaged in an "obvious attempt to control financial market across the globe."

Wall Street may not approve, but I certainly do.

I'm only sorry that our own feckless leaders didn't make the tough decision to take the same actions several years ago when they had the chance to fix this mess – instead of taking the easy way out with trillions in bailouts that we can't possibly pay back.

What the public doesn't understand about naked credit default swaps is that they are not the effective insurance policies Wall Street has everybody believing them to be.

Simply put, buying a naked credit default swap is like taking out fire insurance on your neighbor's house. Now you have an incentive to burn it down so that you can get paid off, which is precisely what global investment bankers have been doing – generating billions of dollars in profits and costing taxpayers similar amounts in the process.

The Self-Fulfilling Prophecy

The key to this whole mess lays in something called an "insurable interest." In the old days, you had to actually own the underlying assets to obtain insurance, because having an ownership stake meant that you had property that required protection.
But the "naked" credit default swaps that are causing such big problems right now are an entirely different animal. They're "insurance policies" written on assets where there is no ownership interest.

Thanks to this financial voodoo, financial firms all over the world are being allowed to bet on the probabilities of an event occurring – the failure of a financial institution or an entire country, for instance. The trouble is that by placing these bets, they have a vested interest in seeing that event come true.

They also have the financial firepower to accelerate the process, which is precisely what appears to have happened with insurance giant American International Group Inc. (NYSE: AIG), Lehman Brothers Holdings Inc. (OTC: LEHMQ), and a whole host of other institutions around the world.

That's why Germany has taken these actions. Today's naked credit-default-swaps market is played by relatively few participants, accounts for trillions of dollars and has the potential to nuke the global financial system – which is why investing icon Warren Buffett so astutely described derivatives such as credit-default swaps as "financial time bombs."

While I believe there is a role for these and other types of derivatives, that role clearly isn't being fulfilled as they are being used right now.

The Vested Interests

Needless to say, the financial heavyweights that have been profiting from this global gambit aren't happy about Germany's decision because they are like a bunch of party happy people who see a 24-karat punch bowl filled with their favorite libation being whisked away while the party's still rocking.

But that's not the worst part.

Financial giants like Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM) and dozens of the most powerful financial-trading firms in history aren't above tanking the markets so long as they can rake in billions in profits from these financial instruments.

It doesn't matter which direction the markets are headed (although, as we've seen, it's even better when they can influence that direction): These firms profit as long as there's "action" in the markets. And that "action" can be described with one word: Volatility.

Germany's push to add some regulatory muscle is designed to calm the markets, and decrease that volatility. Based on the way the investment-banking brethren are already reacting, I think it's pretty clear that Germany's finally struck a nerve.

Personally, I think Germany should take things a step further and require that any foreign firm doing business in Germany, or with German institutions, should comply with German rules worldwide. New York State already does this with insurance companies, so this is not without precedent.

The way today's global financial firms operate – and the financial instruments they employ – are so complex that there's no single agency anywhere on earth that can police their actions. That's why I've pushed for unified global action since the global financial crisis began.

And by "unified global action," I'm not talking about bailouts, either.

Those have been a complete waste of time from Day One, and have done nothing to address the fundamental issue: Wall Street – and the financial instruments that it has engineered – is out of control and answerable to no one.

And Wall Street firms know this, which is why they are reacting so vehemently to Germany's regulatory riposte. These rules could strip away a lucrative revenue stream, so you can rest assured they and their lobbyists will do everything they can to nip this in the bud.

So far it appears to be working if for no other reason than Germany stands alone. At least for now.

If you're not of the same opinion, ask yourself why Wall Street lobbied so strongly leading up to the Commodity Modernization Act of 2000, in which derivatives and swaps like the ones in question were made exempt from official financial reporting. The latest estimates of the total value of credit default swaps written worldwide range from $30 trillion to $75 trillion – or more. In the world of estimates, that's quite a disparity. And the reality is that nobody really knows, because the swaps market is completely unregulated and reporting requirements are largely voluntary.

Wall Street likes it that way: After all, you can't regulate what you can't see.

Then ask yourself why LIBOR (the London Interbank Offered Rate) and credit default prices have skyrocketed since Germany's announcement. overnight. The LIBOR rate is supposed to represent the lowest possible interest rates banks charge to each other because, theoretically, they are each other's best customers. If the banks were clean and not dealing in these things, rates should be falling, especially with the announcement of the $930 billion (nearly 1.0 trillion euros) European bailout package now on the table.

However, the reality that rates spiked signals that the banks increasingly don't trust one another – perhaps because they all have financial skeletons in their closets.

It appears that Germany is the first to really see the light on this issue and that it's going to take other key economies awhile to do so. Denial can be a powerful emotion, particularly when elections are just around the corner, as they are in the United States.

And that means we're going to see credit default swaps shift to other markets in the days ahead because the political will to implement a concerted and coordinated global response simply doesn't exist.

Moves to Make Now

The bottom line is that we need to do one of two things worldwide:

  • Either outlaw these financial instruments entirely.
  • Or require them to be brought into the light of day – and onto regulated exchanges – in a very short period of time.

Expect Wall Street to do what it has always done: Pull out all the stops – and pull in all the lawyers and lobbyists – to avoid a regulatory renewal that would take away the party punchbowl and the dry up their profits.

Granted, as individual investors, we have limited influence on that outcome (although I encourage you to write to your representatives, and let them know how you feel … print out this commentary and send it along with your letter or e-mail).

But we can absolutely take steps to protect ourselves – and even profit – from the situation at hand.

So no matter what your investing style or preference and whether you agree with me or not:

  1. Cover your assets: Make sure that you have protective "stops" in place or have deployed options that help hedge your risk.
  2. Take out insurance of your own: Purchase your own credit default swaps in the form of such "inverse" funds as the Rydex Inverse S&P 500 Strategy Fund (RYURX) or the Rydex Inverse Government Long Bond Strategy Fund (RYJUX), which profit when markets go haywire; these will provide important stabilizing influences on your portfolio that allow you to stay in the game even as others watch their financial futures get vaporized.
  3. Create a shopping list: Get your "Buy list" ready; if we get even half the storm I think is possible based on how the markets reacted yesterday (Wednesday) to Germany's CDS ban, the massive declines waiting in the wings could create some truly legendary buying opportunities.

[Editor's Note: Money Morning's Keith Fitz-Gerald is still perfect.

With his latest trade, Fitz-Gerald is a perfect 23 for 23 with his Geiger Index advisory service. A veteran trader, skilled analyst and noted market tactician, Fitz-Gerald is able to see through the confusing haze of today's quickly changing markets, which enables him to visualize and understand what the future holds. This ability to see into the future -predicting looming changes while also divining the profit opportunities those changes will create - is one of Fitz-Gerald's greatest strengths.

That's a big reason that Fitz-Gerald - Money Morning's chief investment strategist and the editor of the New China Trader advisory service - has maintained a perfect record with the Geiger Index.

If you would like more information about the Geiger Index, please click here.]

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Peter Bogdan | May 20, 2010

    Keith, Thank you for simplifying the credit default swap imbroglio. Now that I understand it in terms I can explain, I intend to write an email to my address book and to my congressmen, who, by the way, never respond except to ask for money. Keep hammering away about this issue that our elected representatives are not addressing adequately.

  2. bmc | May 20, 2010

    Nice one Keith – tell it like it is!!

    It's sad that Germany seems to be the only nation in Europe also willing to stand up and tell it like it is. Oh the lure of easy money, which ironically costs you more in the end if you're not careful.

  3. Moran | May 20, 2010

    Long long overdue. Could it be our own "feckless leaders" are bought and paid for by Wall St hoods and banksters who have booby trapped the global economy for their financial gain.

    Take it several steps further. Offer bounties (tax free) on the heads of any Wall St manager or senior bankster. Provide one time criminal offense pardons for these er terminations within 90 days. Ban all investment vehicles created by Wall St and banks in the past 20 years.

    Confiscate the capital of all Wall St firms and large banks and deploy to build a new American industrial economy. Write new rules for the financial sector. No more fines for violations. Summary executions/amputations instead by way of local referendums. Ban lawyers (ie politicians) and corporate lobbyists.

    Audit the Federal Reserve and stop juicing economic stats published by govt agencies.

    Ban all idiot culture media oulets, 95% of all TV content, ear splitting car steros, gitch flashing baggy pants and caps worn sideways. Salary caps for all professional athletes.

    Chime in for what I missed.

  4. Paul Kilmartin | May 20, 2010

    Keith, you're a guy I normally agree with, but not today.

    Incompetent Governments attempting to regulate what they don't and cannot understand isn't the answer to anything. In order to get "help" understanding what they're facing, they use "experts" from the field. The result is a stacked corporatist deck, where certain insiders get the advantage over other insiders.

    If naked CDS's are such a bad idea, then the appropriate remedy is for firms — such as your cited example of AIG and Lehman — to fail. Getting governments involved only makes the matters worse. In their attempt to accelerate a correction which markets would take anyway, Governments (even when they are well intentioned, which they often are not) will always introduce unintended consequences. I note you didn't mention Germany is also banning short selling equities. When has such a ban ever worked out?

  5. Michael Hampden | May 20, 2010

    If the CDS ban was such a good ideas then why are markets tanking off the back of it?

    Also, we've been able to short the market without 'insurable insterest' for decades with puts and futures without the world falling apart. Why is a CDS any different? It's just a method of shorting credit. Some investors who buy equity puts are speculating – sure and why not? Free market economics, foundation of post-war prosperity – love it. Many others have perfect legimate reasons to want to hedge their equity portoflios. Nothing wrong with that either, in fact it seems like a good thing. Why shouldn't the fixed income world have similar tools?

    Are you seriously suggesting that Wall Street firms try to manipulate the EUR 2trillion bund market or the EUR300bn Greek govvie market using CDS? Hedge funds and prop desks using the $9bn of Greek sov CDS or the $4bn of German sov CDS net outstanding to move the government bond market – to "burn it down". Doesn't really ring true does it?

  6. Jeff Pluim | May 20, 2010

    Keith, you're the best. Your view on this topic is both informed and well thought out, as usual. I am impressed that Germany has taken this step, but considering their exposure to the potential of huge losses in this EU bailout of Greece, it makes perfect sense. I know that their move to restrict trading in these derivatives will only have limited effect unless the rest of the major players in the world, get on the same band wagon. If other governments don't follow suit then it will only become a matter of time until Germany's move is minimized by the speculators/banks moving from Germany to other markets that allow these destructive devices. The markets have responded to Germany's move by pulling their money. Unless other countries/markets follow Germany, it may turn out that Germany has shot itself in the foot. It was a bold, daring move, that I am sure Germany hopes is followed by other countries/markets soon.

  7. Rudy | May 20, 2010

    Bernie Madoff should have had these powers too. He could have banned withdrawals and run his Ponzi scheme longer.

    Government finance has been run as Ponzi scheme for many years. Bonds are issued with no intention of repayment. Old bonds are paid off with new bonds. Every Finance Minister in the world would be in jail with Bernie if they didn't have political power.

    Yes, punish those nasty speculators for exposing the government theft of investors money.

  8. GARY TRAYWICK | May 20, 2010

    I admire the action Germany has taken, not because of any inherent interest of the
    Government to protect the citizenry but, rather, to protect their financial sovereignty.
    We are speeding unabated toward a precipice and seemingly no one, especially
    governments, know how to put on the brakes. Drastic circumstances demand drastic
    solutions, and the hackneyed approaches of yesterday are no resolution to today's
    calamity. Right or wrong – Germany is taking a stand and making a statement. I
    applaud them for taking what can only be interpreted as a common sense
    FIRST step approach toward sanity in a crazy world.

  9. Mark Koss | May 20, 2010

    Keith,

    It was just that the Commodity Futures Modernization Act did not require reporting it also banned the SEC, CFTC, and all State insurance regulators from regulating theses CDS'. IT also effectively said that CDS' were not insurance contracts.

  10. James | May 20, 2010

    I agree with you. This article should be sent to our Congressmen. They are like us and do not understand the complexiities of credit default swaps. Thank you for your clear and simple explanation. If I can understand our Congressmen should too.

    In the whole matter of credit default swaps, shouldn't the Federal Reserve and Treasury take the initiative and lead in outlawing it in the US like what Germany is boldly doing? That is the first step to global financial reform. Where is Ben Bernanke and Timothy Geithner in this matter? They are the economic super brains and know exactly what is going on. And they have the power and clout to initiate changes. My guess is they answer to the Big Banks and Wall Street who are after their own self-interests and are opposed to getting rid of this "destructive" device. What the Big Banks and Wall Street should know is getting rid of credit default swaps is good for their own self-interest too in the long term, since if left unguarded, our whole global economic system is bound to collapse, not now, but in the very near future. We are witnessing wild riots in Thailand and just witnessed a milder one in Greece. Are these signs of the times and more events like this to come in the future? Next is Portugal, then Spain, the United Kingdom and not too far down the road, maybe even right here in our own backyard in the US.

    I hope the US follows Germany's lead and do what is right and not appease to the Big Banks and Wall Street before it's too late.

  11. Thomas Aldrich | May 20, 2010

    I'm glad that at least one of our world governments has the courage to do the right thing. I only hope that many others will soon follow in Germany's footsteps. We have pandered to big business for far too long. We help prop them up and they "reward" us by taking their factories to third world countries, along with their jobs which helped create a strong middle class, the same middle class they have been trying to destroy for the past 4 decades! Perhaps we also need to rid ourselves of all the corrupt politicians and lobbyists that are paid to support those same big businesses that pollute our world.

  12. Carl | May 20, 2010

    Right on Keith. It is high time that states reclaim their sovereignty from the markets. Their responsibility for the well being of their citizens has got to be shielded from the 'games' of the market. Our 10% unemployment came from Wall Street shenanigans, and the irresponsibility of the government to maintain the required discipline. For the second time in less than a century we have proved to the world that unfettered, free-market capitalism is not the answer. The fetters we put on the markets after the Great Depression were and are necessary. They served us well for 70 years. Unlike the aftermath of World War II, we are not the only viable economy in the world, and will no longer be making the rules that everyone else has to live by. I agree with a previous responder and share his disappointment that our government is not up to the task. The banks own Washington and I don't expect our political culture to mature to the point of responsibility required to make the system work effectively.

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