Quantitative easing - no -sell CDS

One thing governments are bad at is intervention in markets. The only success I can think of is the time when the HKMA bought a slug of Hang Seng index shares during the Asian crisis to put an end to the interest rate - property stocks shenanigans that were going on. What's more, after the crisis, the acquired shares were sold at a profit.

At the moment in the UK we have too much credit and not enough lending. At the same time interest rates have been cut and money market meddling undertaken in order to restart the lending process. The interest rate changes have had little impact - pushing on a string - as some commentators say. The reason for this failure of policy is that, thanks to the CDS market, the price of credit and the overall cost of borrowing have become detached.
So Mervyn King should step in and sell credit protection (CDS) in all the UK financial names.

This has many benefits and few drawbacks.
a) Selling reduces the price and so the cost of credit as measured by the CDS spread would decline. The lower CDS value would lower the cost of cash borrowings for these institutions.

b) It is so cheap - in fact selling means that HMG receives regular premiums from the buyer of the CDS protection. These are only a small percentage of the underlying notional debt but could be used to buy back cash debt in the underlying institutions or to buy their shares or for the money to be applied to whatever financial support measure the government has in mind. This would help close the gap between the cash and credit markets.

c) Unlike quantitative easing a) the impact of the CDS sales activities can be readily seen from market prices and adjusted more rapidly than interventions in the money market and b) there is no long-term such as hyper-inflation; once the CDS term is reached, the liability expires and the notional credit disappears.

d) By upsetting the players in the CDS market, the government might be able to bring to an end the derivatives monster. This is where all the credit is lurking and hence we have the paradox of seemingly too much credit in the system but not enough in the real world. Initially, the CDS sales are creating more credit but once the market has decided that it can't win against a sovereign that is backing the underlying credit, the CDS market would shrink. At this stage, the regulators can then step in to control banks' further exposures to derivatives by, for example, changes to the capital adequacy ratings for such instruments.

e) As CDS market players have found, you get a lot off bang for your buck. So don't waste money in cash bondmarkets, invest in derivatives where you can have some impact.

f) As CDS is essentially a form of insurance, HMG could reassess the level of guarantees it has set for the UK bank indebtedness. Maintaining a blend of CDS and guarantees would help bring equilibrium between the cost of credit, the credit risk of banks and the credit risk of the sovereign.

While the government has many consultants, I note that Mr Brown's key adviser is probably Baroness Vadera. Methinks her knowledge of day to day trading in CDS and cash bondmarkets might be limited, given that she left Warburg's in April 1999 - when CDS was the plural of compact disc and the Euro was only 3 months old!

But there again, is Dr Bernanke up to date? How much notional credit was wafting round the credit default swap markets in the 1930's? Is his study of the Great Depression that relevant or do we need the blend of barrow boys and quant jocks that got us into the mess to tap away on their laptops (another consumer staple of the 1930s) and find a way out?