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Regulatory Risk Abounds!


The witch-hunt widens on Wall Street.

There are a few overlapping dynamics in play, which is why this juncture is particularly tricky. There's the reality that European contagion could manifest despite the austerity measures currently being adopted. While Greece bought itself some time with last week's €5 billion 10-year bond auction, their public debt is roughly €300 billion, with €53 billion due this year -- and €20 billion due by the end of May.

Juxtapose those obligations against the massive counter-party risk in a finance-based global economy tied together with upwards of $500 trillion dollars in notional derivatives and it becomes clear why the European Union is attempting to create an IMF-style bailout fund, which they hope will take shape by midyear.

Let's assume policymakers learned from the first phase of the financial crisis, that they'll be proactive rather than reactive in their efforts to snuff out the next fuse of contagion. Those measures will likely be centered around sweeping regulatory reform of the vehicles that are used to make bets on the outcome they're so desperately trying to avoid.

One potential "solution" is to suspend Credit Default Swaps as speculative vehicles and allow only the institutions that hold the underlying bonds to use them to hedge their holdings. If such regulation is adopted, the knee-jerk reaction could be a "melt-up" in the marketplace, much like we initially witnessed in September 2008 when short sales in the financials were banned. See Martial Law for the Markets.

Given the quest for global financial stability, such legislation wouldn't be a shocker; it would, however, be far from a panacea for a few reasons. First, the chasm between a prolonged political process and the dynamic markets creates implementation risk. Let's remember, capitalism almost flat-lined before a panic-induced plan was finally voted into place.

Second, there will be unforeseen unintended consequences for our intertwined financial world. In addition to the mechanical shifts -- the ever-changing process of shorting stocks, the re-pricing of put premiums and the repositioning of risk -- casualties of war will invariably be linked to other institutions.

Finally, credit default swaps were not the root cause of the financial crisis. While they make for an easy mark -- and to be fair, exacerbate the volatility of the underlying vehicles -- they're not the problem, in and of themselves. This regulation, should it come to pass, will buy time and effect price but it won't alter the prognosis for the global economic condition.

The cumulative imbalances have been building for many years and the true source of stress -- untenable debt, excessive leverage, wildfire derivatives and reactive policies -- won't magically disappear with the wave of a regulatory wand. True medicine that cures the disease -- as opposed to synthetic drugs that mask the symptoms -- will only arrive when we swallow the bitter pill of debt destruction. See also Anatomy of a Recession.

To be sure, a new sheriff should step into the Wild West of CDS; there needs to be a semblance of order, a monitored process and a regulated procedure. A coordinated initiative to reign in speculative bets will achieve the desired near-term outcome but it has profound implications for the future of free markets, or the traditional definition thereof.

The options being weighed are in many cases a choice between the least of many evils. Given the destination we arrive at pales in comparison to the path we take to get there, bulls and bears alike would be wise to respect the potential effect of this sweeping regulatory reform.

No positions in stocks mentioned.
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