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.]

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 is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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