European Central Bank And CDS: Is It A Possibility?

Includes: FXE
by: Douglas Borthwick

Today it costs $5.8 million USD upfront and $100,000 USD a year to purchase insurance on five-year Greek debt. The purchaser buys the protection and sends the checks to the writer.
Currently the ECB buys Peripheral debt in the market, taking Greek paper and writing a check to the seller.
The ECB is taking the view that default will not happen. In taking this view it writes checks to those who sell the Greek debt to them.
What if the ECB asked the Federal Reserve to sell CDS in the peripherals on behalf of and with themselves?
It would be much harder for a speculator to write a check for $5.8 million USD and send it to the Federal Reserve or the European Central Bank when taking a bet on Greek default. They would be writing a check to the one institution that can guarantee default will not happen.
We believe that the most illiquid product in this European debt crisis is the CDS market, and yet its movements have forced the yields higher across the European debt spectrum. I don't know whether the ECB or the EFSF has the ability to write CDS, but if they do, or if they find a way, then the results of their actions could prove to be a turning point on the constant pressure in Europe. Writing CDS on the peripherals takes a much stronger market stance than buying the debt in that the speculator has to look the ECB in the eyes when they write the check.
I admit I am no expert in the CDS market, but I do understand that it is rather thin. We believe that a strategy such as this would catch the market unaware, and thus have a desired effect. Note that German Chancellor Merkel said the EFSF will expand instruments against contagion. Would those instruments include the ability to write CDS?
Such a move would pull down the yields on peripheral bonds and take some pressure off the markets. It could result in a "run for the exits" in the CDS market, one where the exit is very small. Often the best response in a situation as dire as this is for "non-standard measures" to be enacted. This would be one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.