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A Shift in Sovereign Sentiment


The specter of CDS regulation arrives.


Last Thursday, with the S&P roughly thirty handles below current levels, the tone of the tape was tenuous at best. After a fall from grace that started the 2010 race, tension was thick and moods were sour as we edged into the requisite two-day respite.

As shared Friday in The Wild Wild West of CDS, the tape suddenly turned higher in a furious fashion when headlines hit that the SEC was examining "potential abuse and destabilizing effects" related to the use of credit default swaps. It was a topic familiar to Minyans, for just a day earlier we mused:

"One must wonder how much ammunition is left in sovereign arsenals. While munitions likely remain -- along with the Howitzer that is sweeping CDS reform -- I can't help wonder, yet again, if the last bullet will be pointed inward. That's not a pleasant thought, I know, but there's a difference between negativity and reality."

This week, we offered that "2010 might be the year we see a massive regulatory overhaul for these opaque financial products," I noted the significant overnight improvement (as measured by tightening spreads) in mainstay European countries.

Minyan James inquired on The Exchange that followed the column:

"The tightening spreads are interesting. What does it mean? Just to say 'this is happening' doesn't help me establish any position in anything, to either make or lose money."

Fair enough, although I would offer that our goal is to provoke, rather than shape, thought. I've long believed there are no pundits; that financial literacy is a movie, not a snapshot; a life-long process, not a sound bite or a lightning round. You'll bear the burden and reap the rewards of your decisions and as we don't know you're time horizon or risk profile, we can't tell you what to do.

But alas, I digress; we'll always share what we're doing, how we're doing it and when it's being done, in real-time, with hopes of effecting positive change through financial understanding.

Through that lens and back on point, 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 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; tightening spreads suggest the government honors it's obligations. As perception vacillates, the spreads adjust dynamically.

There are a few overlapping dynamics currently in play, which is why this juncture is particularly tricky. There's the reality that contagion might manifest in Europe as the next phase of the financial crisis, mirroring the stateside ride lit by the sub-prime fuse. Greece will likely get bailed out, much like Bear Stearns (JPM), but there will be more; perhaps many more.

Professor Peter Atwater first drew this analogy a full year ago and I recently mapped the five-step guide to help Minyans find their way.

And there's regulatory environment, which is likely playing more of a hand in the current CDS volatility. This morning we awake to find further tightening in the sovereign space, with France (-14%), Portugal (-13%), Germany (-11%), Italy (-10%), Ireland (9%) and Spain (8.5%) all showing massive improvement.

Did "things" improve that much in two short days? Nope, the cumulative global imbalances took years to build and they won't magically disappear overnight. The catalyst for the shift is an extension of what we touched on last week but this time, the European posse is on the move.

Minyans will remember that in September 2008
, when the wheels fell off the financial wagon, the markets reversed course and raced higher when Britain's Financial Services Authority announced they banned short selling on financial stocks. We're not talking upticks here; we're talking about short selling. Period.

Today, we receive word that banks and regulators throughout Europe have been summoned by the European Commission to discuss regulation of sovereign CDS and will hold a meeting as early as March 5th to better understand the nuances of this unregulated market. As we've repeatedly offered, if they rule against speculation in CDS -- and allow buyers to purchase this "insurance" only when they own the underlying bonds -- we could see a short squeeze in the credit space (that will quickly migrate to equities) akin to what we saw when the U.S followed suit on the short sale ban.

Is it the smart thing to do? Sure, if you're interested in staving off global financial collapse, this will surely push risk out on the time continuum. What it doesn't solve, however, is the root cause of the problem -- untenable debt, a cacophony of derivatives and the deteriorating social mood that is an unintended consequence of policy to date.

As a matter of perspective and while I have you, I'll draw your attention to the price action surrounding the short sale ban we referred to earlier. The S&P rallied 130 handles -- a full 1000 points in the DJIA -- into and after the news only to wilt under the weight of an unfortunate reality. History doesn't always repeat, as Mark Twain famously said, but it sometimes rhymes

Click to enlarge

We're not dealing with a perfect world here. The decisions being made are in many cases the least of many evils and a natural by-product of reactive policy following years of societal largess. Through the lens of "the destination we arrive at pales in comparison to the path we take to get there," however, bulls and bears alike would be wise to respect the potential effect of this sweeping regulatory reform.

Good luck today.


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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at

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