IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Despite the widely held view that the European sovereign debt crisis, and the euro itself, have been stabilized, we are not alone in the opinion that the deep problems not only remain but have probably been exacerbated by the ECB’s actions. Far from being addressed, these problems have only been masked by ultra-loose monetary policies (such as quantitative easing “QE”) and are likely to re-emerge when and if there is any significant reversal of these policies.
We are not the only commentators to observe that the process cannot stand still, that Monetary Union must be strengthened and be seen to be economically succeeding. Laslo Andor, a former European Commissioner, together with thirteen prestigious bankers, economists and former politicians have called for the establishment of a European Financial Executive, reporting to a ‘parliament of the eurozone’ with powers to set budgets, issue debt, establish common insurance funds to backstop the financial system, and issue safe assets should any country default upon its debts. Recognizing that this proposal is radical, Mr Andor and colleagues brazenly describe the dire present position and how we reached it:
“The last few years have shown that the institutions governing the eurozone are not fit for purpose in preventing crises and even less so in managing them. Economic policy orchestrated by an ineffective combination of complex rules, erratic market discipline and loose inter-governmental cooperation arrangements cannot continue to be the way forward for the eurozone.
For now, the European financial authorities appear committed to an entirely different next step. In January, the European Systemic Risk Board (ESRB) published its long-awaited 600-page recommendation for a new kind of European sovereign financial instrument called Sovereign Bond-Backed Securities (SBBS). The idea is a simple but audacious recommendation to pool and securitize Eurozone sovereign debt, hoping that eurozone banks will hold only ‘super safe’ assets and that foreign funds will invest in the riskier tranches. The report suggests that SBBS may be established as early as May this year.
The report envisions a new public institution establishing a series of entities that will purchase euro zone member state sovereign bonds and finance these purchases by the issuance of three tranches of securitised notes; the senior tranche is expected to be sized at 70%, the mezzanine 20% and the junior 10%. The entities could be viewed simply as securitisation special purpose companies. The ESRB hopes that these companies will be unguaranteed, ‘standalone’ entities, but the rating agencies will have the final say on whether any additional support is necessary. Any losses or payment disruption resulting from non-payment by a constituent sovereign entity would be absorbed initially by the junior bond, next the mezzanine and only in the last resort by the senior.
Returns are estimated to be comparable to outstanding sovereign bonds with senior yields tracking German bunds, mezzanine yields tracking the government bonds of Italy and Spain with Junior yields tracking Portuguese and Greek.
The ESRB expects the investor base for senior notes to comprise mainly euro area banks, who would switch out of their existing holdings of domestic government bonds. Mezzanine investors would be asset managers, life insurance companies and pension funds. The junior piece would be priced to attract high yield investors such as private banks, family wealth offices and hedge funds. The ESRB envisages that over time, SBBS programmes could account for €1.5 trillion, approximately 17% of the €9 trillion eurozone government bond market.
The Benefits of SBBS, According to the ESRB
The ESRB highlights four benefits of implementing a SBBS programme:
We are not convinced. The first point is ideological at best. The extent to which settlement system imbalances would be reduced depends upon the uptake of all SBBS by foreign investors and purchases of the junior tranches by investors located in the stronger countries. The lack of a risk free asset has not been bemoaned by market investors. Indeed, there is some skepticism as to whether the correlation risk among countries links somewhat closely the default risk of the senior and the two junior tranches.
The Challenges Before SBBS Can Be Issued
The ESRB report also recognises the difficulties of implementing an SBBS programme, notably three:
First, the rules will need to be changed to encourage banks to buy the senior notes. As presently envisaged, SBBS would be deemed securitised bonds and would ‘consume’ higher levels of bank investor capital compared with ordinary sovereign bonds.
Secondly, there may be problems achieving the desired AAA rating for the senior securities. Standard and Poor’s commented a year ago that 19 countries is too few for default risk to be assessed on their ‘random’ models, and that the tranche ratings would therefore be no higher than the rating of the weakest country in each tranche, meaning that the senior notes would be rated well below AAA without additional guarantees or cash collateral.
Thirdly, SBBS will only work if investors are confident that debt levels will converge and reduce towards Maastricht levels. This could surely only start to happen if presently reviled policies of fiscal austerity were introduced. This seems to us highly unlikely without systemic shock or the European Financial Executive idea proposed above by Laslo Andor and colleagues.
Conclusion – Our View on SBBS, Likely to Happen but Perhaps a Looming Policy Error
Returning to the claimed benefits of SBBS, it seems to us that the second ‘benefit’ listed above simply states the primary objective of the SBBS project – unwinding QE. The ECB and the national central banks (NCBs) fear the consequences of reversing QE by selling government bonds, especially of the weaker countries, into the markets.
For these reasons, we believe that SBBS is very likely to be implemented. Banks throughout Europe are flush with liquidity owing to ECB policies such as QE and repurchase facilities. However, our reading of the ESRB report is that there may be a policy error looming. It is beyond dispute that the SBBS concept is pure financial engineering. We fear that, just as with US sub-prime mortgage securitizations in the years immediately preceding the Great Financial Crisis, the effect of such pure engineering may be to prop up an unstable market, sucking in naïve investors and propping up for a few years a debt market that would benefit more from a correction today. How might this policy error unfold? Consider the ‘doom loop’ between banks and sovereigns, the elimination of which is one of the stated objectives of SBBS. Let us explain.
Domestic banks in the weaker countries (including Italy) own around 90% of that portion of their own sovereign’s debt that is in private hands. Such large domestic holdings of domestic public debt ensures that banks and their sovereigns remain effectively conjoined in a credit risk sense, which – it is justifiably claimed - in turn prevents Europe’s banking system from functioning ‘normally’ and impedes further Monetary Union. But this doom loop exists for perfectly rational reasons. By way of example, Greek sovereign debt yields the highest returns of all the eurozone sovereigns. Despite the perceived high level of risk, Greek banks doubtless consider that their own continued existence depends upon their sovereign remaining solvent, and therefore are happy to own their government’s debt.
Two scenarios might unravel when SBBS are launched. One scenario is that the ‘Doom Loop’ remains intact, and national banks continue to own 90% of their sovereign’s privately held debt (for non–economic reasons); in which case they will not be persuaded to sell these bonds and buy senior SBBS, and the whole exercise will fall flat thus damaging the credibility of the European financial authorities.
Alternatively, SBBS might succeed initially and break the doom loop, spreading the sovereign debt of even the weaker countries among banks of all nineteen eurozone countries. However, with the doom loop broken, there is a risk that a default of say, Portugal, will be less able to be contained within Portugal. With losses on bank-held Portuguese sovereign debt (albeit in SBBS format) more likely to spread to banks in other eurozone countries, the risk is of chaotic bank defaults across the eurozone.
On a positive note, we take heart from the fact that the SBBS project is being promoted so strongly; its very existence confirms the view we expressed in the opening paragraph, the problems are deep and the ECB is running out of ideas. Attempting to restructure the entire Eurozone sovereign debt market whilst changing the rules to encourage banks to buy SBBS is a bold plan which surely bureaucrats should not be attempting. Perhaps the recent electoral success of euro-skeptic parties in Italy will contribute to reining them in.