If you are worried about what will happen to all those eurozone bonds once the European Central Bank (ECB) stops buying them, take a look at a new proposal, miraculously published just as talk about the end of ECB asset purchases was starting to make investors nervous.
More than half a decade after the eurozone debt crisis, the single currency area is slowly approaching consensus on a measure that markets have been begging for: joint eurobonds. But investors should curb their enthusiasm: as with anything out of the European Union, the current proposal is a fudge that may, or may not, work; moreover, it may take years to implement.
The European Systemic Risk Board (ESRB), the organization established in 2010 to oversee the eurozone financial system and diminish systemic risk, earlier this week published a proposal so simple that one has to wonder what took the EU so long to come up with it: package eurozone sovereign bonds up into asset-backed securities (ABS).
Predictably called sovereign bond-backed securities (SBBS), these would work pretty much like any ABS: they would be backed by a "diversified portfolio of euro-denominated central government bonds," and would include "varying levels of seniority," the ESRB said in its report.
What would be the difference between those securities and a joint eurozone bond? Well, each sovereign nation will remain liable for its own debt, rather than the risk being mutualized as it would be the case if a joint eurozone bond were issued. But because various countries' debt will be packaged together, the risk will be spread out. This gets around Germany's opposition to joint bonds because of the danger of mutualizing risk.
If this reminds you too much of the mortgage-backed securities that went sour in 2007, sparking the financial crisis, it's because they have things like the pooling of various assets and the tranching of risk in common. But unlike in the case of the mortgage-backed securities, it can be argued that the assets backing the SBBS would be more transparent and safer, because sovereign bonds usually are.
The pool of sovereign bonds participating in these SBBS assets would be weighted by the ECB's capital key -- this is the proportion of capital each eurozone member contributes to the central bank's capital. Around 70% of the SBBS would be high-rated, senior debt; the remaining 30% would be composed of a 20% "mezzanine" tranche and a 10% junior tranche.
"These securities would offer higher returns and embed higher risks: any non-payment on bonds in the cover pool would be borne by holders of the most subordinate security, according to a contractually-defined automatic cash flow waterfall," the ESRB report explains.
Just like for other asset-backed securities, issuance of SBBS would be done by bankruptcy-remote vehicles -- special entities that are separated from the public or private institution that originates them. This ensures that the buyers of the SBBS do not get hit if the institution itself goes bankrupt.
The mechanism of building the pool of assets that backs the securities is intriguing, because it implies that eurozone sovereign bonds could be bought straight from the primary markets to be included in the pool.
This seems like an elegant way around another German taboo -- the requirement that government debt should not be monetized (i.e., bought by central banks straight after issuance) in the euro area -- as these bonds would be bought by private, not state institutions, at least in theory.
"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," according to the report.
So, why was this wonderful idea not implemented before? If it had, it would have probably saved the ECB billions in eurozone bond purchases and would have offered more alternatives to yield-starved investors out there.
The main disadvantage of these securities, according to the report, is that they receive an "unfavorable regulatory treatment compared to sovereign bonds" as they are riskier. This "helps to explain why they have not yet been created."
In other words, if a bank were to buy a SBBS, it would not be considered by regulators to be an asset of a quality that is similar to a plain vanilla eurozone government bond. Under current regulation, sovereign bonds are hard to beat by any other type of asset, because banks are not required to hold any capital against them.But there is talk about changing regulations to allow for more flexibility and to discourage concentration of sovereign debt risk, and if such reforms are enacted, SBBS could turn from a well-presented project into real, investable instruments. Perhaps not just in time to pick up where quantitative easing leaves off, but, if regulators get their act together, close enough.