01 October 2016

Paul Goldschmidt: “European Safe Bonds”: The latest in a series of false good ideas!

The EU’s first priority must be to secure its own unquestioned survival so that the EU and the Euro become a State with a currency similar to that of other Sovereign issuers. All attempts to circumvent this inescapable logic would only enhance the likelihood of the Euro’s ultimate collapse.

The most recent Working Paper (N° 21) issued by the European Systemic Risk Board outlines a sophisticated proposal for the issuance of European Safe Bonds (ESBies) aimed at creating a Safe European Security whose characteristics would (apparently) be safer than German Bunds, reduce the diabolical “Sovereign – Bank” loop while simultaneously increasing significantly the potential for creating low risk assets that would benefit from a zero weighting in calculating bank capital requirements.
 
The ideas put forward bring creative answers to some of the stumbling blocks that have inhibited until now the issuance of “Eurobonds” (except securities guaranteed by the EU budget or by entities benefitting from the joint and several guarantee of all Member States (EIB) or EMU Members (EMS)).  
 
Indeed, the proposed structure is specifically designed to avoid pooling of liabilities, each country remaining solely responsible for servicing its national debt. It is being achieved in two steps:
 
1. Creating “asset backed securities” secured by a portfolio of national debt securities.
2. “Tranching” the portfolio into senior (70% ESBies) and junior (30% JSBies) tranches with the intention that the senior tranche should prove less risky than German Bunds!
 
I will not attempt to contest the mathematical calculations “demonstrating” the level of risk of ESBies but I believe that they fail to consider altogether a major element of risk that is purely and simply ignored: the risk of redenomination.
 
For as long as the Euro is not viewed as a currency linked to a single “Sovereign”, that means a fully-fledged (federal) State, the risks incurred by a holder of ESBies (senior and junior tranches) remain largely unquantifiable, all the more that if redenomination occurred (especially in one of the main EMU countries) the contagion effect would be magnified leading to the implosion of EMU and a (painful) return to national currencies. Such an event voids all the calculations in the proposal. It also points (intuitively) to the much better position of an investor in Bunds that is likely to suffer far less than an investor in ESBies even after redenomination into “New Deutsche Marks”.
 
It follows that completing EMU is a precondition of making the scheme viable. On the other hand, if EMU is completed involving political and fiscal integration, then having recourse to such a complex proposal becomes an unnecessary complication. The new “Federal State” could issue unlimited amounts of debt” with the complicity of the ECB. The risk involved by the “foreign” investor would be the likelihood of “devaluation” and for the “domestic” investor the erosion of purchasing power through the phenomenon of inflation. These “Eurobonds” would have largely the same characteristics as US Treasuries to which the paper refers to several times.
 
In addition to this key redenomination risk, there are other areas of uncertainty: though the scheme calls for all issuers of ESBies to draft their contracts under the same “law”, it does not unify the laws under which the underlying assets are issued, each sovereign borrower remaining totally master of its own issuance. As most government debt is issued as a pari passu “senior” security, default on the bond held in the portfolio of the ESB issuer would trigger a default on all the debt of the issuer of the underlying bond. The most likely outcome is therefore a restructuring of that country’s debt (and a strong probability of redenomination which was avoided in Greece and Cyprus because of the relative small size of their issuance and the feasibility of an EU rescue package which negates one of the proposal’s key objectives). This also means that any “default” will affect all outstanding ESBies and JSBies which certainly points to the advantage  of centralizing issuance through a single public institution in order to ensure equality of treatment between ESBies and JSBies investors respectively.
 
Another point that is overlooked is the risk of “acceleration” in case of a default affecting the JSBies. In case of a restructuring of the debt of a Member State, how would the “new securities” received be apportioned by the ESB issuer between the tranches? One can see here that the experiences incurred in the Subprime crisis, in which many “senior” tranches became insolvent through a cascade effect bankrupting successively from bottom up the different tranches of securities, could well be replicated in the structure proposed in the paper. In any case a foolproof design seems difficult to achieve, and if it were, then the yield premium demanded by investors in JSBies might become unmanageable within sensible market parameters. [...]

European Systemic Risk Board paper

Full article on Paul Goldschmidt website

 

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