Safe assets and how to protect the euro from the next crisis
Back in 2011, at the height of the financial crisis in the Euro Area, there were many ideas flying around about how to make the single currency safer. In particular, how to avoid a problem in the finances of one member state blowing up into crisis for the entire currency.
A lot of effort went into developing the idea of a Eurobond - a single asset to spread the risk. This ran into the brick walls of practicality and political aversion - nobody then (or now) wanted to take on the liabilities of high debt states that ran loose fiscal ships.
One group of academics did come up with a way of creating a new highly liquid, super safe asset that was market based, and so avoided all the political and legal problems of fully fledged Eurobonds. They called them "Esbies" x European safe bonds. We wrote about them at the time.
Unlike many of the ideas from back then, the Esbies didn’t go away. And nor did the people who came up with them. Most significantly one of the originators of the idea, Professor Philip Lane, went on to become a governor of a the Central Bank of Ireland, and a member of the ECB governing council. He also went on to chair a high level task force of the European Systemic Risk Board (ESRB) on safe assets.
Today the ESRB published the fruits of what a Euro area sovereign bond backed security might look like.
In short it refines the original idea of pooling normal government bonds issued by Euro Area states, and repackaging them into a new type of collateralised security, using tranching to have a super safe senior tranche, and a riskier junior tranche that would take the first loss in the event of default.
After involvement in the idea by market participants, today's report proposes two key changes to the original. First, the creation of a third, mezzanine, tranche, that would be riskier than the senior, but not as risky as the junior (and priced accordingly).
The second change is to link the weight of countries participating in the safe asset by GDP, not the amount of outstanding debt they have (this would stop countries relying on too much debt in their balance sheets, and make sure there were no free riders loading up at others expense).
The idea is to keep market discipline on sovereign debt issuance, but avoid the destructive effects of small sovereign disturbances on the single currency as a whole, and the borrowing costs of governments.
According to Governor Lane, the senior tranche (based on 2016 prices) would have a yield just slightly higher than German bunds. The mezzanine tranche would yield somewhere between Italian and Spanish bonds, while the riskiest junior tranche would have a yield somewhere between Portugal and Greece.
Because the risk is pooled, and the liquidity is deep, the structure should be safer than the ordinary government bonds underlying it. According to the ESRB research, a default by no small country could risk the junior tranche, which would only face loss if one of the four biggest states defaulted.
So who would issue these safe bonds? Well, not governments. They would continue to issue sovereign debt as usual. It would then be bought by a special purpose vehicle (SPV) that would repackage them into the new safe security, collect coupons, pass them on to investors etc. Philip Lane called it a "robot".
Crucially, the SPV would have no decision making role in the underlying securities (ie if a government decided to default), it just processes the paperwork.
Here is what the report says about how the SPV would work:
"Issuance of SBBS could be arranged by private entities, subject to standardisation requirements, or by a public entity, conditional on political agreement regarding the appropriate institutional architecture. To assemble the cover pool, arranger(s) could purchase sovereign bonds at competitive prices on dedicated primary markets, which would require national debt management offices to coordinate their issuance strategies.
Alternatively, arranger(s) could obtain sovereign bonds on existing primary or secondary markets, which might require them to temporarily fund a warehouse of bonds while assembling the cover pool. In this case, private sector arrangers would require compensation for bearing warehousing risks, while a public sector arranger would require participating Member States to agree to contribute a limited amount of paid-in capital.
To minimise the need for these funding sources, arranger(s) could make use of a (binding) order book, whereby investors submit purchase commitments before arranger(s) assemble cover pools.
Regardless of the identity of the arranger(s) and how they assemble the cover pool, SBBS-issuing entities would be bankruptcy-remote from the arranger(s).
The sole activity of issuers would be to issue SBBS, hold the cover pool of sovereign bonds and pass cash flows from those assets to investors in SBBS. Issuers would not receive any public guarantees or paid-in capital. All securities would be placed in the market, with no retention by issuers.
As such, issuance of SBBS would depend entirely on the level of demand for each of the three securities.
Demand would vary according to investors’ risk appetites and constraints imposed by regulation, which would influence their required return and the consistency between SBBS yields and the yields of the cover pool.
Depending on investor demand, the SBBS market could develop incrementally at first, similar to initial issuances of bonds by the European Stability Mechanism, which have attained adequate liquidity despite limited volumes.
Over time, SBBS could reach much more substantial volumes in the order of €1.5 trillion or more, conditional on the continued smooth functioning of sovereign bond markets with respect to liquidity and price formation."
Markets ought to like the idea, as it would give them a benchmark product for the Euro Area, with a big pool or risk free instruments. Governments too should like it, because it doesn’t need treaty change (though it would need an EU regulation).
It would also underpin the banking union and capital markets union projects the EU is working towards at the moment. But will the markets go for it? The idea is out there now, in great detail, for in depth consultation. If any big idea from the crisis stands a chance of making it into real life, this is probably it.