This is an idea building on elements of the U.S. Term Asset-Backed Securities Loan Facility from 2008.
The EFSF and/or ESM could use its funds to cover potential losses the ECB could incur on its purchases of bonds of countries under market stress -- up to a certain amount.
In this way the ECB would have a guarantee it would not lose money on the bonds it buys to smooth out market turbulence under its existing program aimed to improve the transmission mechanism of monetary policy.
Depending on the assumed loss, the money at EFSF disposal could guarantee bond purchases many times its size. Like an insurer, it would only pay out in case of a default -- an unlikely scenario for Spain or Italy.
For example, the EFSF could say it would cover the first 20 percent of losses that the bank could suffer in case of a default -- multiplying the EFSF's firepower fivefold.
The problem with this solution is that it would require the ECB to continue buying euro zone government bonds, which the bank does not want to do, as it can be perceived as helping finance government fiscal policies.
I am not sure I buy what is written above, because, very frankly it doesn't make a lot of sense. The part "ECB buys bonds, and then covers the first 20% loses in the bank" is very fuzzy. If you want to leverage the pot it is fairly easy and let me see if I can put the words back in order following the US example.
You sell a sort of CDS, at a preferred rate to the market rate.
1/ The bank is effectively backstopped, it could say pay the first 20% default but a steeper fall would fall on EFSF. So the book value would be discounted to 80c on eur much better than the current 60-50% haircut. Banks like that, markets like that because it puts a floor on the loses.
2/ The collateral you have to post is the EFSF. If it has 440B in capital and you assume a 20% prob of default you are leveraging 5X or 2Trillion effective coverage. Yep, THAT will do it.
3/ it may violate maastricht as it will target banks, maybe not, I don't know and in any case I don't expect the individual governments to block this.
4/ probability is that NOTHING will default (outside of greece), the EFSF gets the premium. Now, a premium like this has a price, a steep price let's say 5% (no idea), on 0.5T that is 25B, that is a small cost for the full protection.
5/ It is an effective way to take all the risk on public purse. Of course the 'Armageddon' scenario that all debt blows up will completely blow up the EFSF since it only has 20% of the collateral. But by then QE should be a palatable option for everyone involved.
6/ This effectively STOPS the greek contagion by creating a federal insurance for the banks.
In a previous post I had argued that they needed QE to leverage the EFSF but what they have done is leverage it via CDS like constructs with the banking system. Absolutely brilliant shock and awe without resorting to QE (if inspired by the Geithner trip I suppose).
Of course Greece will still default and what they do is still up in the air, but as far as 'contagion' goes this is over.