Yesterday, Germany Banned Naked Short-Selling at Midnight and Politicians Declared War on the Markets.

Today, the markets responded with a shock and awe of their own. Please consider Swaps Soar on Germany’s ‘Act of Desperation’

Credit-default swaps soared as German Chancellor Angela Merkel’s curb on using the contracts to speculate on European sovereign debt sparked concern among investors about increasing government regulation.

The Markit iTraxx Crossover index of swaps on 50 European companies surged 50 basis points to 582, according to Markit Group Ltd., while the Markit iTraxx Asia index on investment- grade borrowers outside Japan climbed 10 basis points to 131.5, Royal Bank of Scotland Group Plc prices show. The jump in the indexes signals a deterioration in investor perceptions of credit quality.

Prohibiting speculation in the contracts may cause trading in swaps tied to Europe government bonds to freeze up, said Tim Backshall, the chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. Trading limits may increase borrowing costs or limit the flow of capital, he said.

Sovereign CDS

Credit-default swaps on Europe’s most indebted governments fell initially on concern the restrictions on short-selling will devalue existing agreements. They erased those declines as it became clear Germany failed to persuade other nations to join in the ban. A Europe-wide prohibition on the practices is “doubtful,” according to Eddy Wymeersch, chairman of the Committee of European Securities Regulators in Paris.

German Chancellor Merkel said today the prohibition on short-selling ban was part of an attempt to gain control over “destructive” financial markets.

Merkel and French President Nicolas Sarkozy have called for curbs on speculating with sovereign credit-default swaps. EU Financial Services Commissioner Michel Barnier called this week for stricter disclosure requirements on the transactions. Last month, the EU proposed that the Financial Stability Board, set up by the Group of 20 nations to monitor financial trends, “closely examine the role” of swaps on sovereign bonds.

“In some ways, it’s a battle of the politicians against the markets” and “I’m determined to win,” Merkel said May 6. “The speculators are our adversaries.”

BaFin itself said two months ago it found “no evidence” that credit-default swaps were being used excessively to speculate against Greek bonds. Depository Trust data “do not support the conclusion that speculation is taking place on a massive scale,” the regulator said in a March 8 statement on its Web site.

Read that last paragraph closely.

BaFin put the ban on short selling even after it announced that it found “no evidence” that credit-default swaps were being used excessively to speculate against Greek bonds.

Is that an act of desperation or panic? How about both?

Mike “Mish” Shedlock
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