Beyond Germany's Short-Selling Ban Is a Bigger Problem

German Short Sale Ban
German Short Sale Ban

Doubts about its actual impact may be rising quickly, but Germany's surprise ban on the naked short-selling of shares in certain major German financial institutions and eurozone bonds was enough to rock the markets on Wednesday. Stocks around the world tumbled, and the cost of insuring some European debt soared.

The financial transactions Germany banned Tuesday are fairly sketchy practices, but the skeptics have a solid case. The territorial limitations of the solitary German move are glaring, for starters. Even the iconic Deutsche Bank (DB), with its main trading floor in London, is exempt.

The ban also includes a provision restricting the purchase of credit default swaps to those who own the underlying securities. French authorities have already come out against the German bans, citing concerns about liquidity, but some commentators have noted that French banks are among the largest writers of credit default swaps in the world, and a similar ban on shorting some French financial institutions has been in place since the depths of the financial crisis two years ago, which limits the benefits of this week's action.

Still, investors would be wise to look past the technicalities of the ban and focus on the broader public sentiment in Germany, the country bearing much of the financial brunt of the European credit crisis. Massive popular anger is emerging at whimsical financial markets. And beyond the superficial German measures, a growing regulatory fervor is catching on.

This will eventually take a toll on the financial sector. In some respects, this situation is reminiscent of the wrangling surrounding Goldman Sachs (GS) about a month ago: Here, too, investors would do well to focus on the big picture rather than the narrow legalities. Goldman's vows to fight Securities and Exchange Commission's civil fraud charges haven't prevented the bank from shedding $26 billion in market capitalization.

Did Mercurial Banks Create the Debt Crisis?

At the crux of the problem are diverging accounts of who is to blame for the ongoing European debt crisis. Accounts on this side of the Atlantic are relatively straightforward: Overly indebted countries such as Greece lived large and provided lavish benefits to politically powerful unions, and they're struggling now that the bill has arrived.

But many prominent commentators are focusing their ire on the role of reckless credit markets that doused the region with cash during boom times, then abruptly turned off the spigot when the winds shifted, leaving taxpayers on the hook.

"The financial markets financed the orgy and now, in a panic, are refusing to finance the resulting clean-up," noted Martin Wolf of The Financial Times. "At every stage, they have acted pro-cyclically."

The spike in sovereign debt yields that took place as many troubled economies sought to roll over their massive debt loads was the latest evidence of this destabilizing, pile-on effect. As investors dumped the bonds, yields rose and credit became that much more expensive for the slew of countries that needed to refinance. As a result, European authorities eventually were forced to assemble a $1 trillion bailout package and the European Central Bank had to intervene, causing much consternation.

In the process, reckless creditors seem to be getting a free ride. Countries like Greece have avoided talk of restructuring debt, implying that their lenders will be paid back in full, though Greece's credit ratings have been downgraded to junk status and stand to gain little as a result. Haircuts for foolish bondholders seem increasingly likely as outrage over this disparity grows.

And many European leaders are now tired of dancing to the tune of the credit markets. "In a way, it is a struggle between politics and the markets," German Chancellor Angela Merkel said in unveiling the new measures. "We must reestablish the primacy of politics over the markets."

More Restrictive Legislation Is Coming

Some savvy European operators already seem attuned to this new political reality. Deutsche Bank CEO Josef Ackermann, who has played a constructive role in handling the crisis, recently expressed doubts that Greece would be able to manage its debt load. And though his comments were widely portrayed as idle speculation about Greece's possible demise, they actually signal that Deutsche Bank -- a major creditor for European governments -- is bracing itself to take losses on its positions rather than expecting to be made whole.

The real political crunch, though, may hit hardest at hedge funds and private-equity funds. Increasingly seen as the epitome of speculatively, socially useless excess, those types of freewheeling investment vehicles are the subject of a surge of limiting legislation on the Continent.

Details about the nascent rules remain skimpy, but tighter regulation and scrutiny of such funds are almost certain. Stringent limits on fund-raising and manager pay may also be in the cards.

Banks such as Goldman Sachs, Morgan Stanley (MS) and JPMorgan (JPM), which have big exposure to hedge funds or private equity stakes, could also take a hit as Europe adjusts. But the entire financial industry is likely to feel a greater headwind from the growing European resentment about the sector's influence.