German Chancellor, Andrea Merkel announced yesterday that she wants Germany to ban ‘naked short selling’ and hopes to push a similar ban for all of the Euro Zone. After the initial euphoria of last week’s proposed $1 Trillion dollar bailout of troubled European nations, to stem the tide of the Debt Contagion, a funny thing happened. The ‘Realists’ moved in and began shorting the Euro and bonds issued by the nations with serious sovereign debt problems. This sent European markets down and sales of physical gold and other precious metals up.

‘Naked Short Selling’ involve contracts, usually Credit Default Swaps (CDS), where those buying the bets against the bonds and such have no direct stake. In the recent case of mortgage-backed securities, many buyers of subprime mortgage tranches, bundles of subprime home loans, would buy a CDS as an insurance policy to protect themselves should the loans default. AIG, America’s ‘favorite’ insurer, issued billions of these. But, they also sold naked CDS as well, usually to savvy hedge funds.

With the Debt Contagion causing a new round of financial crisis in Europe, starting with the Greek debt, a flurry of CDS sales against bonds issued by Greece, Spain, the UK and others has occurred. Again, it’s the hedge fund firms doing most of the buying. And, once again, it’s our old friend, AIG, insuring them! I guess they figure if Uncle Sugar will bail them out once, the taxpayers will bail the out again. In the world of these exotic derivatives, we’re also seeing ‘synthetic’ investment instruments, more bets for and against the success of the Euro and the Euro Zone.

Bloomberg reports today that one such trader, Kyle Bass of Hayman Advisors LP, is making just such a play. In 2007, he cleaned up on some $500 Million shorting mortgage-backed securities. Now, his hedge fund has targeted the Euro, buying naked shorts plus positive positions on gold futures. His fund is also doing likewise to the Yen and U.S. Dollar, too! He is not alone.

Nick Swenson of Groveland Capital LLC has also jumped on the bandwagon. Actually, he may have been leading it. Back in March, Swenson began buying CDS on bonds from Spain, Ireland and Italy. “It’s asymmetric, it reminds me of the subprime trades” he told Bloomberg. As fears of the Debt Contagion worsen, he started buying CDS on 26 Euro nation bonds! Even after such CDS options declined in April, Swenson is holding firm, predicting that as many as 1/3 of those countries will either default or restructure their sovereign debt.

Other hedge fund groups following suit include Matrix Group and Corriente Advisors LLC. John Paulson, the man in the middle of the Goldman Sachs-Abacus deal, who made $15 Billion shorting mortgages, is oddly enough sitting this one out. While he’s not buying CDS shorts on Euro bonds, he is buying gold, telling his clients that inflation will jump soon. So far, other European countries have yet to join Andrea Merkel in efforts to ban naked short selling. So the sovereign debt CDS market looks to remain a healthy one as the Debt Contagion hangs over the continent.