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When Angela Merkel announced a ban on naked short selling of certain stocks and bonds, including naked credit default swaps, the yelps from the usual suspects in the business press were woeful when they weren’t silly. Here’s a headline from an internet ranter: “Does This Woman Have Any Idea What She’s Doing?” The ranter asserts that the only reason to do this is that she “lacks confidence in European financial stability”. The Wall Street Journal on-line sees it as an attack on all short sellers, and provides a stern lecture about the wonderfulness of all markets.
The WSJ writer eventually gets around to admitting that naked short sales are already illegal in the US, and that they are destabilizing and dangerous. What he isn’t willing to discuss is fraud.
Merkel’s ban makes perfect sense. One of the major justifications for credit default swaps is that they make it possible to short bonds. E. Gerald Corrigan, Managing Director of Goldman Sachs, and former president of the New York Fed along with other impressive titles and memberships said so in his written testimony to the House Committee on Agriculture in December 2008.
Here’s how short selling gets to be a problem. Years ago, I was a junior lawyer working on a proposed sale of stock of a small but growing client. There was a thin market in that stock, and as we got closer to the sale date, the price of the stock began to drop. Eventually the underwriter told the client that it would have to lower the sale price of the stock. The client didn’t really need the money so it pulled back, and the price of the stock went back up. So the sale went back into action, and the price went down again. This time, the client killed the deal, and made other arrangements for money.
What happened was that short sellers drove the price down, expecting that this would lower the price of the offering, and that they would cover the shorts at the lower price. This is easy to do in a thinly traded market, because sale of a small number of shares will affect the price.
How does apply to Germany? Speculators claim that there is a market in CDSs for sovereign debt, debt issued by governments. If trading in the tiny number of CDSs constitutes a market, it is certainly thin, both in size and in the range of players.
In November 2008, there were CDSs on German debt with a gross notional value of approximately $40 billion. On May 14, 2010, that had risen to $72.6 billion. In November 2008, there were 719 total live contracts; that rose to 2,179 in May 2010. In addition, there is trading in indexes called ITRAXX SOVX Western Europe Series 2 and 3, where there are 2830 more contracts. These are indexes corresponding to unweighted averages of 15 European nations, including Germany and Greece.
Wall Street has convinced people that the prices in these “markets” indicate the credit-worthiness of Germany. If these prices rise, interest rates on new German bonds will rise. Germany is going to have to issue a lot of debt to pay for its share of the Greek bailout. If selling naked CDSs drives interest rates up, bond buyers will benefit directly at the expense of the German people. The likely bidders for those bonds include units of the giant US banks, like JPMorgan Chase, the largest US dealer in CDSs, with $78 trillion in gross notional value. German CDSs are a rounding error for JPMorgan.
The German CDS market is thin, and therefore easy to manipulate. Angela Merkel thinks that is happening, and the French Finance Minister Christine Lagarde raised concerns in February 2010, along with others, according to the New York Times.
It isn’t a transparent market either, which E. Gerald Corrigan thinks is good thing:
…[C]onfidentiality enables risk managers to isolate and transfer credit risk discreetly, without affecting business relationships.
The only information about CDS trading is self-reported. There isn’t any reason to trust the players in this market to report accurately, or to refrain from fake trading to affect prices in the near term.
Look at the situation in Greece. In November 2008, there were 1,132 CDS contracts; that rose to 3,857 in May 2010. It is another thin market, even when you add in the SOVX indices.
Some players in this market know more about Greece than others. Goldman Sachs was helping Greece hide the extent of its financial problems. It could easily have used that knowledge to speculate on Greek bonds, and in many other ways.
Is there anyone who thinks market players wouldn’t cheat Greek or German citizens for a few bucks?
——-
The information about current outstanding CDSs is from DTCC. The historical data is from my file, copied from DTCC at the time.
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At least Angela Merkel has a spine.
Great post Masaccio; FDL is ‘blessed’ to have your expertise.
“This is easy to do in a thinly traded market, because sale of a small number of shares will affect the price.”; this is true of any market, for instance, palladium and platinum in the commodities markets.
“Wall Street has convinced people that the prices in these “markets” indicate the credit-worthiness of Germany.” And whomever these ‘people’ are that Wall Street has convinced really need to wakeup.
Good for Merkel. Being able to naked short CDS’s is obscene. It’s nothing more than financial arson, but our lawmakers apparently don’t think so. Spineless bastards.
Glad to read that someone else is applauding Merkel on this. The guys at clusterstock went crazy. A series of links can be found here:
http://real-economics.blogspot.com/2010/05/germans-fight-back-against-banksters.html
There must be a reason American lawmakers and regulators are protecting this behavior. Perhaps we’re simply not in on the secret. Clearly, they know best. I bet another backrub would solve Angela’s issues.
And Martha Stewart went to jail for what? This is insider trading on steroids. And market manupulation, which is supposed to he a crime in this country.
Merkel seems to be one of the few world leaders with any cojones.
The rest of those wall street owned poodles could lear a lot from her. Rather than NOt understanding the amrkets, she is showing a deep understanding of the markets, how they work, and how corrupt they have become
It’s about dam time. Do you think traders in this country didn’t naked short, or that they just went to desks in Germany and France and did it? We’ve been trying for years to get the Euro’s to stop this stuff, but they wouldn’t, because they weren’t the one being hurt by it, we were.
I think there’s a good chance insider trading in CDSs is legal. Check out this post.
Really helpful post. And yet the French and others were unhappy that Germany acted unilaterally, without consultation with other EU member or Euro-group members, even with their usualy partners, the French.
masaccio — if the argument against naked CDS is the thinness of the market, meaning their price revealing is suspect and subject to manipulation, is there some established threshold for saying, “okay, it’s deep enough to trust the prices”? Or, since there are only a handful of mega banks involved in this, (apparently true in the US) is the market always likely to be inherently suspect, unable to present a credible measure of the risks/value of the underlying bonds?
Because there’s a distinct difference in the understanding of capitalism between the U.S. and Germany.
In Germany markets are supposed to assist growth and stability in the economy, when they do the opposite, they tame them.
In the U.S. the economy is supposed to provide the cash to speculate with in the markets, and when it doesn’t the government injects it.
Germany has an economy, the U.S. has a facade. It’s been this way for decades.
Christine Lagarde and Angela Merkel (why is it that there are so few women in this business, and most of them get it right?) seem to think that the problem is that only a few banks are in the business. Think of the opportunities that Goldman Sachs has for market making.
The thinness of the market just makes it easier and cheaper to fool around. Even one rogue bank could do it. Suppose JPMorgan was going to buy a big position in European Greek bailout debt when it comes to market. They could drop in a couple of cheap bids and change the price, even if the other players were playing fair, whatever that means.
I don’t trust any prices in this market. No one knows anything, it’s just like that Iowa political market, where truth is supposed to emerge from random players betting their hunches. I think the whole thing is a total sham.
X2 of #12
This is laudable as far as it goes but you have to keep in mind how far it goes. This was a German defense of Germany and German banks. Merkel didn’t do this to help out Greece, the other PIIGS, even France, the euro, or Europe generally. And that’s the problem.
A GREAT read and beautifully explained piece regarding short selling, market manipulation!
As in Deep Capture, short selling while flooding the market with phantom stock can break a company, or a country, for that matter.
A terrific laymans read you’ve put together for us non finan pro’s . . . outstanding.
*bows*
And as others in comments have said, it’s illegal, it’s insider trading and manipulation, and it’s all certainly NOT in the interest of we the people, be we here in USA or Greece, Germany, anywhere.
These horrible activities can topple governments and countries in the blink of an eye. And certainly can be used to ‘leverage’ or pressure or blackmail entire governments/
Way to go Angela. Keep the “BOYS” in line.
Thank you Masaccio for your expertise.
Andrea Merkel is showing leadership… you do what is best for your country. When will a real leader on these matters come forward in the U.S.? When will we truly stop the corruption that has taken place in our financial institutions? Masaccio, I agree that market prices can’t be trusted…there is just to much corruption now.
Yes, and the government and the Fed have been injecting the money which the markets have been playing with a bit, not really making enough long term business growth investments, mainly sitting on growing mounds of cash. Krugman then warns of deflation because there isn’t enough money circulating in the general economy itself, the Fed continues to find ways to infuse more liquidity which finds its way to the wealth class, which they sit on some more. It’s all good for the rich.
Nicely woven . . . thanks.
If the six biggest banks control more than 60% of the U.S. financial assets, do “we the people” have control of anything in this country?
Ummmm, do you have any personal wealth you could take to another country?
Thank you for the informative post. I’m a little fuzzy on how some of this works, so it’s helpful. Also glad to hear the at least one world leader has some sense. But I agree with a prior comment that Germany’s economy is run much differently from ours. Still, good to know that Merkel took this step. Would like to think that others will learn, but I won’t hold my breath.
What a great site. There is a really interesting essay on Sheldon Wolin’s “Democracy Incorporated: Managed Democracy and the Specter of Inverted Totalitarianism “(favorite book of mine) and Thorsten Veblen. Managed Democracy Now?
In the essay I referenced about Veblen, the author zeros in on the difference Veblen made between industry and business. And the more industry grows oddly and inversely the business people become more barbaric. They don’t know mechanics and don’t want to. They fight industry. Is that what you are getting at with Germany? Germany is very much now the leading industrial nation. From Bosch to Volkswagon/Audi they still make stuff…really really good stuff. They put a great deal into apprenticeships in industry. They place their graduates in companies as interns. They use finance as a lubricant, but hardly a industry. So the government is there to help industry first and for the reason of helping their society as a whole.
But it will largely be unaffected by it because the largest banks, the ones that booed this ban are located in – London and New York City
As long as you understand who’s poo-poo’ing this ban, then you’ll understand its mostly cosmetic.
The PIIGS debt problems are largely caused by American, French and Anglo Banks.
If you really wanna understand what’s going on in Europe watch DW via their web site or Link or RT.
I can no longer watch our news media especially when it talks about other countries, just like Dylan Ratigan likes to say things like “Stupid Germans” some how saying that Europeans are easily fooled by elitist American Bankers.
Greece’s political elite wanted to hide their debt from the EU at large and when they could no longer hide it, they go around the world looking for help. Greece, a country that’s 2% of the EU economy and what’s the real reason for this bail out package largely from Germany? To prop up the Euro and prevent French and British Banks from taking the hit. If they actually did what they should have done and put Greece through Bankruptcy, there wouldn’t be this need for a bailout…
http://www.youtube.com/watch?v=F5XIF2P5nJ8
http://rt.com/About_Us/Programmes/Keiser_Report/2010-05-18/571486.html
Even Jim Rogers is even sure about the Euro
That is important to keep in mind for evaluating both why all German governments regardless of party affiliation (remember that Merkel is a conservative, with a free market extremist sidekick) are honestly in favor of “closing the casino” — and why that fact doesn’t matter.
Frankfurt’s finance industry vs the German economy is microscopic compared to Wall Street and “the City” vs the US and the UK economy respectively. It is even small compared to the French or even Italian finance sector.
Germany has little to loose and much to gain (i.e. capital, which would flow back to companies actually producing tangible stuff) by stopping the gambling, because Germany is hardly playing (and almost never winning).
Naked short sellers are a menace to the public. This is a “public nudity” even the most ardent left-winger should be against!
The trade involves simply betting small money that a company or a bank will not continue to be profitable, or not be able to meet its ongoing liabilities (its debts). Perhaps, go bankrupt.
Unlike a normal (clothed?) short, who must first borrow the stock or bond before they sell it short, a naked short simply bets that the security will go down. They never have to own the security, and they never have to give it back (buy it back and return it to counterparty) like a regular short.
So Merkel is right on the money by enforcing the ban.
If you are confident that a bond worth $1000 is going to go down in value because of company trouble, borrow the bond from a broker, sell it for $1000, and then wait until your prediction comes true and buy it back for $700 and give it back to the broker (keep the $300 difference as your gain). If you’re wrong and the bond goes to $1100, pony up the extra $100.
But buying a CDS for $10 against the same bond, in the hopes it will go to $300 is just an invitation for speculators to go out and talk down a company so that the wish comes true.
Funny you should mention that. I just spent the last two weeks taking some of my “personal wealth” to another country.
Is the future one in which there is one global economy and the U.S. will just be a bit player in the bigger picture? For example, we now have the United States with individual states. Will the individual countries around the world become the “states” of the world? The United States would be the “California” of the world…one of the largest. If something like this happened, would it be in our best interests? Would that be “progress”?
With all the political corruption from within our government from both Democrats and Republicans, “we the people” seem to have lost this country on so many levels.
It seems like it would be better to trade it on an exchange rather than still keep the market secret while also making the market be even smaller by reducing who can trade in them. Let the trading happen in an open market, so people can see what is going on. If the market now is self-reported and those reporting not being trustworthy, you can’t say what size the market is and also that it couldn’t be from lying about the trades that affects the markets rather than the trades themselves.
Hard to see what the fuss is all about -
Germany has banned naked shorts in the past – and then removed the ban
Doing a naked short in some other country on any given security has the same effect as doing it in the US given our Global economy.
Until the US (and rest of world) gets as tough as Germany as to depth of regulation, and Germany (and rest of world) adds regulation so that it mirrors those regulation areas like naked shorts that the US has and Germany normally does not, the game will continue. Indeed this should be a WTO priority rather than forcing countries to not protect jobs in their country.
Yup, Merkel gave the speculating parasites a wedgie. Left them scrambling to cover short positions. City of London and Wallstreet were not amused.
Too bad that leaders in France and the remainder of Europe are not yet following her leed.