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.