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Opinion: Germans resist naked swaps

German and US officials try to prevent the spread of the Greek debt crisis.

German Chancellor Angela Merkel at the lower house of parliament in Berlin on May 20, 2010. Merkel on Thursday called for a global levy on banks, a new European rating agency and a coordinated exit from stimulus measures as Germany stepped up efforts to drive financial regulatory reform. (Fabrizio Bensch/Reuters)

BOSTON — The “D” word — derivatives — achieved pariah status again this week on both sides of the Atlantic as governments continued their epic battles to rein in an unwieldy financial system.

In an effort to curb speculation, Germany’s Federal Financial Supervisory Authority banned the purchase of credit default swaps on government debt unless investors own the underlying bonds. The U.S. Senate Senate Thursday passed a sweeping financial reform bill that requires most derivatives to be traded on exchanges and prevents banks from trading them.

Even though it seemed like the world was on the road to recovery, the Greek debt crisis has reawakened old and painful memories of how much damage the 2008 financial collapse caused. With Greece, it feels like we are now doomed to relive the Lehman debacle in country form.

“The risk is that the European situation will spiral out of control, spread within Europe beyond Greece and push Europe back into recession, and further damage the U.S. and global economy and financial system,” Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics, told the U.S. House Financial Services Committee on Thursday.

Twenty percent of U.S. exports go to Europe, and at the end of 2009, half the total foreign exposure of U.S. banks, or $1.5 trillion was in the European Union. “The world economy will not recover without a reasonably healthy European recovery,” Truman added.

Germany has pledged $31 billion, France $25 billion and other eurozone countries about 28 percent of the trillion-dollar bailout package for Greece. The International Monetary Fund (IMF) will provide the rest; the U.S. contributes about 17 percent to the IMF. The U.S. Federal Reserve has reopened foreign exchange swap lines to a number of foreign banks to maintain liquidity and prevent credit from freezing up like it did in 2008.

German Chancellor Angela Merkel banned “naked” credit default swaps on government debt (those that do not own any underlying bonds), from exacerbating a dire situation.

When an institution lends money to a country by investing in a bond, it can also buy a credit default swap from a separate party that insures the investment just in case the country cannot repay the loan. Credit default swaps help eliminate the risk.

The crazy part of credit default swaps is that an investor can purchase them without owning any of the underlying debt or asset. Naked swaps can lead to intense betting against companies or countries when they are in their weakest position. It can result in the same kind of speculative frenzy that many believe contributed to the final downfall of Bear Stearns and Lehman Brothers. Only this time, the speculation could hurt not just Greece, but all 16 countries that use the euro.

"If the euro fails, Europe fails,” Merkel told members of Germany’s parliament on Wednesday. “If we do not avert this danger, the consequences are incalculable.”

In the web of international capital markets, speculators on European debt can cause a chain reaction to U.S. markets, just as speculators against a U.S. company can ripple into the European banking system.