Germans Ban Getting Naked

Austria is not Australia. Sorry about that.

Late last week we reported that the Australian Mint sold more gold coins in the first two weeks of April than it had in all of the first quarter combined. That was a mistake. It was the Austrian Mint, which makes a lot more sense, given that nearly all of the sales were to Europeans who are in a mild state of panic about the stability of their currency and their banking sector.

Speaking of which, a few weeks ago we speculated that Germany might be an earlier victim of the sovereign debt crisis because its various banks and financial institutions own a lot of Spanish and Portuguese debt. Credit default swaps were blowing out faster on German debt than other sovereign nations in which deficits and debt were bigger.

But this is really a question of where risk resides in the credit system at the moment. And the market is pointing somewhere in the middle of Europe. So if you were a speculator, or merely wishing to hedge your position in German financial stocks, you’d buy credit default swap insurance. It seems like a sensible thing to do, although apparently you can’t do it anymore.

Bloomberg reports that, “The euro slid to its least since April 2006 after Germany prohibited naked short-selling and speculating on European government bonds with credit-default swaps and the Bank of Italy allowed lenders to exclude losses on government debt.” Hmmn… Is this like not being able to buy health insurance if you have a pre-existing condition?

Investors unable to hedge their risk may have to sell. Or, short-sellers will have to cover, which means you could get a brief rally in European shares, the euro, and euro bonds. But it’s hardly the sort of thing to boost confidence. Another Bloomberg article elaborates: “Germany will temporarily ban naked short selling and naked credit-default swaps of euro-area government bonds at midnight after politicians blamed the practice for exacerbating the European debt crisis.”

The key words here are “naked” and “politicians”. Naked short selling, unlike the covered kind, is selling a security you don’t own instead of borrowing it first and then selling it. There’s a healthy debate about whether you can or should be able to sell something you don’t own or that isn’t owned by anyone. Why speculators are doing it is obvious. Whether they should be able to do it is less obvious.

But that it’s a good investment idea…well that is another matter entirely. And politicians who are blaming euro bond weakness on short sellers are looking for a villain that is not them. It’s a confusion of cause and effect, like blaming the buzzards for the death of the corpse. It does buy them time though, in the blame game.

Banning short selling does not improve the quality of sovereign debt or sovereign finances in Europe. And by the way, we’ve been copping it from European subscribers lately who feel aggrieved. They point out that there are other even more serious debt problems in the UK and the USA. And in terms of flawed currencies, what about the greenback and the pound?

Correct you are, aggrieved Europeans! The dollar’s day of reckoning will come too. But in the mean time, US bonds and the greenback are enjoying the “flight-to-something-else” bid. We wouldn’t call it a flight to safety, mind you.

But it does explain the chart below, which shows the gold price in both US and Australian dollars. Note the price rising in both currencies. And note that the Aussie gold price appears to move up as global investors flee risk (emerging markets and leveraged commodity plays). The greenback gold price is climbing too, but less fast.

Gold in US Dollars vs. Aussie Dollars

Meanwhile, will the centralized slap down on markets in Europe work? The authorities are trying to protect vulnerable institutions by preventing short sellers and speculators from attacking them. And the Bank of Italy’s decision to exclude losses on government debt from capital adequacy considerations is nothing less than inspired. It could start a trend.

It’s not a loss if you don’t count it!

More seriously, why institute the ban on naked short selling now? And why take the extra step of preventing anyone in the market from going short government bonds? To be charitable, you could assume that the asset price falls (especially in government bonds) are the work of evil speculators (the global wolf pack) who are unfairly damaging and destroying confidence in otherwise credit-worthy securities and sound government fiscal policies (cough).

But more likely, if asset values on bank balance sheets are falling (principally government bonds) then it could again trigger the whole deleveraging vicious cycle we saw in 2008 where institutions are forced to sell some assets to cover losses on other assets or loans. You get a whole lot of selling and much lower prices, which is of course exactly what needs to happen…and which is exactly what will happen…eventually.

Dan Denning
for The Daily Reckoning