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Regulatory Risk Abounds!


The witch-hunt widens on Wall Street.

"Up and Down; and in the end it's only round and round and round." --Pink Floyd

The US Department of Justice recently asked hedge fund managers who attended an idea dinner hosted by a boutique broker to document the bets they placed against the Euro, which was one of the 23 themes discussed when they gathered on February 8th.

Ideations are commonplace on Wall Street and thought provocation provides utility when navigating the increasingly complex financial landscape. It's not dramatically different than Minyanville offering our annual themes, or brokers projecting price targets for the mainstay indices; the friction between opinions is where true education resides. See also, Ten Themes for 2010.

Policymakers were swift to respond to the suspected collusion. That same week, the SEC announced they were examining "potential abuse and destabilizing effects" related to the use of Credit Default Swaps. European officials also launched an investigation, with some regulators lobbying for the "fastest possible" implementation of new rules.

I'm not here to defend hedge funds, nor do I believe proper regulatory reform has been achieved following the financial crisis. As a card-carrying capitalist, I'm a buyer of free markets, a seller of obtuse intervention and a believer that those who abuse the system should be held accountable. While desperate times facilitate desperate measures, however, perspective is paramount as we pave the path for future generations.

In 2007, Minyanville opined that that if a Financial Accounting Standards Board could single-handedly sink the entire capital market construct, we must question the stability of the system itself. The same can be said of sovereign defaults -- if a handful of hedge funds can bring nations to their knees, more pervasive issues invariably loom beneath the seemingly calm financial surface.

The request by the Department of Justice speaks volumes about the social mood surrounding free-market capitalism. In this age of Great Divide -- Wall Street vs. Main Street, Red States vs. Blue States, "Have's" vs. "Have Not's" -- it's easy to point fingers and place blame but questions surround the unintended consequences of a regulatory revolt. See also, The Declaration of Interdependence.

The Swap Meet

We recently drew the parallel between the financial crisis that engulfed Bear Stearns (JPM), Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG) and Lehman Brothers and the emerging risk that sovereign defaults could follow a familiar script of contagion. See A Five-Step Guide to Contagion.

Credit Default Swaps are akin to insurance, although they're not regulated as such; the buyer pays a premium for the right to receive money should a particular credit event occur. In the case of sovereign swaps, the buyer cashes in if a government defaults on a bond payment. Widening spreads indicate a higher likelihood of default while tightening spreads suggest a narrowing probability. As perception vacillates, spreads adjust.
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