Hoping to win more public and political support for its involvement in the bailout of Greece, Germany has banned the naked short-selling of European sovereign debt instruments. However, other European governments are refusing to follow suit, highlighting the lack of political will that's needed to regulate the credit default swap (CDS) market.
German Chancellor Angela Merkel said that the ban would remain in place until the EU comes up with a comprehensive plan for financial reform.
"This will all remain in place until other rules are established on the European level," she said.
BaFin, Germany's market regulator, has also placed a ban on the naked short-selling of 10 of the country's largest financial institutions. That ban went into effect Tuesday at midnight and will last until March 31, 2011.
The German public and its politicians view short-selling – the selling of borrowed shares of a security – by speculators and large financial institutions as a major reason for Greece's breakdown. They contend that speculators piled up bets that Greece would default via credit default swaps, making it more costly for the country to borrow.
Credit default swaps are credit derivative contracts that let investors place bets on whether or not a company, or in this case a country, will default. The CDS buyer makes periodic payments to the seller, and in return receives a payoff if the underlying financial instrument defaults.
Think of it like this: If Institutional Investor "A" has a $10 million loan to Megacorp, Institutional Investor "B" can agree to cover the credit in that loan. In other words, if Megacorp defaults, "B" has to cover the debt. But "B" collects a small insurance premium for agreeing to cover the loan – a premium it gets to pocket as income.
However, one of the biggest problems with CDS contracts is that their holders have an incentive to push targets into bankruptcy.
"Naked default swaps are like buying fire insurance on your neighbor's house – you have no ownership interest and every incentive to burn the house down so you can collect your payoff," says Money Morning Chief Investment Strategist Keith Fitz-Gerald. "The difference is that now we have the biggest most profitable financial institutions on the planet potentially burning down literally entire countries and making billions in the process."
Trading in credit-default swaps linked only to Greek debt surged in February, with the overall amount of insurance on Greek debt hitting $85 billion, up from $38 billion a year ago, according to the Depository Trust and Clearing Corporation, which tracks swaps trading.
That, in turn, drove up the cost of insuring Greek debt. The cost of insuring $10 million of Greek bonds rose more than $400,000 in February, up from $282,000 in early January.
BaFin itself said two months ago it found "no evidence" that credit-default swaps were being used excessively to speculate against Greek bonds. Depository Trust data "do not support the conclusion that speculation is taking place on a massive scale," the regulator said in a March 8 statement on its Web site.
But now BaFin has reversed its opinion.
The market regulator on Tuesday cited the "extraordinary volatility" afflicting Eurozone countries' debt certificates and the widening of spreads on credit default swaps for several nations. Of particular concern to BaFin is naked short-selling, in which traders sell securities without borrowing them first.
"Against this background, massive short-selling of the affected debt certificates and the conclusion of naked CDS on loan default risks of Eurozone states would have as a consequence further excessive price movements," BaFin said in a statement.
However, the German ban on short-selling has had relatively no impact on the market.
Credit swaps tied to Greece's government debt climbed 55.5 basis points to 669.5, according to CMA DataVision prices. Contracts on Italy rose 2 basis points to 139, while Portugal rose 3 basis points to 274.5.
"The market sees an inadequate policy such as this as an act of desperation and a refusal to address the fundamental problems at hand," Brian Yelvington, head of fixed-income strategy at Knight Libertas LLC in Greenwich, Connecticut, told BusinessWeek.
Part of the reason for that is because other European countries have not followed Greece's lead. France, which lined up with Germany on market regulation before the last two Group 20 (G20) summits, said it "evisage" a similar ban.
French finance minister Christine Lagarde expressed reservations about such a ban because there is little trading of these instruments on French exchanges. Furthermore, it could reduce liquidity in the European sovereign debt market.
"I think we should really request the views of those governments affected by this measure," said Lagarde. "We did not envisage doing this. And for liquidity reasons, it is useful to continue functioning without banning short selling."
Sweden, The Netherlands and Austria have also balked at increasing regulation – something Fitz-Gerald says is a mistake.
Countries like these "would rather pursue the same failed bailout policies of the past several years than address the tough issues required," says Fitz-Gerald. "Until there is a coordinated global effort to make [the CDS market] transparent and regulatable, it'll be business as usual. Greece is just the tip of iceberg."
"If our regulators were smart they'd follow along quickly," he added. "But I don't think the political will can overcome Wall Street's rhetoric – and that's a disappointment because the attention could easily shift from Greece to the United Kingdom and subsequently to the United States."
News and Related Story Links:
- Money Morning:
Does the EU Bailout Signal the Euro's Demise?
- Money Morning:
Credit Default Swaps Strike Again – This Time Driving Greece to the Brink of Default
Swaps Soar on Germany's 'Act of Desperation': Credit Markets
- Financial Times:
Backlash builds against German ban