Saturday, September 10, 2011

Message To ECB: Why Not Sell CDS, Instead?

With the European debt crisis threatening to tear apart the very fabric of the EU itself, here's an idea (a weird one, I admit).  Instead of buying Italian, Spanish, Greek, etc. government bonds, the ECB could sell the equivalent sovereign credit default swaps (CDS).  


Greek CDS Soar

Yes, it means that the central bank will - in effect - guarantee the public debt of such nations, but it will do so only up to a defined limit (the amt. of CDS sold).  The benefits, beyond the immediate de-escalation of the crisis, are:
  1. The ECB does not balloon its balance sheet.
  2. No money supply issues (no sterilization needed).
  3. Much bigger bang for the buck through the use of derivatives.
  4. The ECB receives income for the protection sold.
Mr. Stark's resignation yesterday from the ECB board makes it clear there is sharp disagreement within the eurozone itself on how to handle the debt crisis - fair enough.  But this doesn't mean that things should be allowed to spin out of control.  In such times markets are guided 99.9% by psychology (fear) and cannot be allowed to wreck the entire European socio-economic structure, put together over so many decades.

8 comments:

RogueDave said...

Once upon a CDS post, you suggested they were not a bad derivative, only that their uses could be applied in financially destructive ways. And the exception to their issuance, was that they should not be permitted to be issued against sovereigns. The post and case was in regard to Denmark, IIRC. Now, you are advocating for them?

Anonymous said...

1 - CDS are part of the problem. Not part of the solution.

2 - Leaving that aside, this look like and elegant solution.

But, for I stick to point 1.

CDOs are smart, CDS are smart, sophisticated SWAPs are smart.

Along with a few others, including a lot of German citizens, I am dumb and dumber by the day. In spite of that, up to now, as a saver, I have not lost a penny in this crisis. And I feel comfortable to be dumb (and more by the day as well).

Should I say that on top of being dumb, I DO NOT TRUST anyone within the banking "profession". That has been an helpful compass during the last three years. BUT I HAVE TRUSTED YOU OVER THESE THREE YEARS AND CONTINUE TO DO SO.

... Even if I do not believe you when you say "THEY will preserve the dollar". Because you are not among THEM, the financiers.

Kind regards for sharing you views.

RogueDave said...

Yes, It was under Barbarians at the Gates, Nov 30 2010, in reply to MacLaren that you wrote:

"In simple terms, CDS has gone from a tool to hedge credit risk to a speculative instrument used to bet against ("short") anything from stocks, mortgages, corporate debt and indexes, to entire countries - indeed entire economic blocks.

I wouldn't have much problem with all of the above - except betting against govt. bonds - if it wasn't for the fact that the self-same bettors turn to govts. and central banks for bailouts, when their bets go sour.

That's what I call Immoral Hazard.

December 2, 2010 12:32 AM"

Anonymous said...

A central bank does not need leverage. They make their own leverage. In fact, their goal is to flood the market with euro's. Leverage is exactly what they don't want.

Using CDS's would only serve to placate stupid people.
Anyone that knows what a CDS is would account for it with the same default risk as the underlying asset. The only difference is that you don't get the coupon payments, you get the price of the CDS instead.

Their balance sheet would look essentially the same.

Hellasious said...

There is a world of difference between a sovereign CDS sold (issued, underwritten) by a central bank and one sold by any other speculator. The central bank is (supposedly) a financial institution focused on public benefit, not profit.

In addition, a central bank can, theoretically, print money without limit and can arm wrestle speculators to the dust - IF IT CHOOSES TO DO SO ("Don't fight the Fed).

In this instance, when speculators/markets are threatening the very existence of the EU itself, I think it is time for the ECB to kick them in the nuts. And keep doing so, until they go away.

Hellasious said...

"Their balance sheet would look essentially the same."

Well, not quite. For one thing, selling a CDS will generate annual income for 5 (typically) years with no up front cash outlay. Money supply will NOT be increased, as it does via unsterilized bond purchases.

For another, derivatives are not included in the assets/liabilities portion of the balance sheet (again, typically).

Even better, for overall effect, would be for the ECB to purchase deeply discounted PIGS bonds AND sell the underlying CDS, thus financing a big portion of their purchases via the market itself.

A one-two punch, which includes a portion of monetary sterilization within it. This will, of course, balloon their balance sheet.

Lord Blagger said...

It doesn't work.

It all involves financial fraud. Namely your premise is that by using a CDS you don't need to account for the derivative because its off balance sheet. i.e. It's just manipulating the accounting regulations.

As for the question, but you receive premiums. Yep you do.

Buy the bonds, and you receive coupons.

No difference.

There is nothing wrong with CDS contracts. Perfectly legitimate and valid transactions in spite of the people who think anything with a TLA must be bad.

It's back to basics. You cannot change the reality by some financial chicanery. Greece is bust. Italy is bust. Spain is bust Portugal is bust. Ireland is bust. Even the UK and France are bust.

The reason why all these countries and more are bust is that they took money for long term liabilities, mostly pensions, and spent the cash. On top, they have no provision for bailing out the feckless.

Hellasious said...

"In the long term we are all... bust" (smile).

..and let us not forget "It's only money". That's the unsung beauty of a fiat currency. It rests on nothing, it means nothing, it accounts for nothing. It's pure and simple faith.

It's as close to the immaculate conception as man has ever come.