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Upon the conduct of each depends the fate of all

Optimize Blog - May 20, 2010 - 0 comments

The latest financial news from the Eurozone is troubling as Germany breaks ranks and acts independently to introduce additional regulation.  Now, we’ve discussed financial regulation before but the concern here is that the German Chancellor, Angela Merkel, has seen fit to impose regulation on a type of trading that really suggests that her view on the financial crisis is at odds with what everyone else is saying and thinking – at least in public.  As most of this type of trading takes place out of London, the actual regulation is likely to have little or no tangible impact as only those banks regulated by BaFin in Germany will be restricted… but the reverberations around Dr Merkel’s motivation for this action are certainly affecting market confidence.
So what happened?  Well, Dr Merkel appears to have unilaterally banned what is affectionately known as “naked short-selling” – essentially the practice of entering into forward contracts to sell government bonds that you don’t actually own.  She has also banned the sale of Credit Default Swaps on sovereign debt… i.e. where traders ‘bet’ on the likelihood of the sovereign state in question collapsing (and defaulting on their debts) by trading related insurance products.  Conversely, and perhaps surprisingly, naked short-selling has nothing to do with inadequately dressed ‘city gents’ offering for sale a selection of vertically challenged members of the public.
As an aside, many of you will recall that one of the features of the original financial collapse was the exponential growth of trade in unclear CDO’s or ‘Collateralised Debt Obligations’ (a bit like a big ‘cooking pot’ full of securitized loans and CDS’s which were artificially sliced and diced and then sold as High , Medium and Low risk investments).  The problem arose when it became clear that no-one had any real understanding of the true risk and value of their ‘manufactured’ investments.  CDS’s were a common ingredient in the CDO cooking pots and are still viewed with distaste by many.
Now, not surprisingly, the markets reacted very badly as they tried to decide if Dr Merkel’s action was the result of some form of political pressure to act (for example, to try to secure parliamentary support for Germany’s contribution to a European bail-out fund), if it was a decision taken out of panic or if it was just basically bad decision making.
Our suspicion is that Dr Merkel has just realised (or has been finally been told) the ugly truth and true scale of exposure levels within Germany’s big banks.  The logic follows that if she knows how bad the situation is, then the market will also soon know – and so she could assume that large scale shorting would be the consequence as traders desperately try to get ahead of the competition.  In this case, of course, it would include the shorting of German government bonds… So, perhaps she acted while she could…?
Perhaps the important thing is that her actions (particularly with regards to stopping the CDS trade) imply that she also expected at least one EU state to follow Greece to the brink of default or beyond – effectively guaranteeing a CDS trading frenzy as the news hit the market, which would then pressure all the other ‘at risk’ countries, leading to a default contagion.  Again, perhaps she has taken action while she could.
So,  is what she did fair on other countries? Probably not.  Is it in the wider interest of the EU ? Possibly – if she acted to block another systemic meltdown of the markets.  Do we actually think she notified selected governments before taking steps? Yes – she will have spoken to some (or at least would have done time permitting) – including the UK, given the size of the market there, and in an effort to recruit them to the cause.  On the other hand maybe not the French, given the obvious distrust between these two European super-powers.
So, as it stands, troubled investors are still wondering why Germany has decided to act unilaterally. Clearly this is not going to help the Eurozone because it needs to borrow heavily over the next few years to stave off the threat of recession and it can only do with support from private investors.
Finally, today in a twist of irony, the German Chancellor made a statement imploring her European partners to act together in implementing tougher financial regulations.  But while Chancellor Merkel continues to raise the specter of the Euro being “in danger” without unified action, her colleagues in other partner countries are doing their best to reassure the markets that the Euro is a stable and credible currency.
With the G20 summit being held in Canada next month, it will be interesting to see how the spirit of collaboration pans out but, in the meantime, those of you in North America should not think that this is happening a long way away… this really is a global issue, with global consequences.

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