European Safe Bonds (ESBies) - (2 of 5)
WHAT DO THE ESBies ACHIEVE?
Our proposal has two complementary elements: changing bank regulation and ECB policy to reflect the risk of sovereign bonds, and supplying a large amount of a euro-wide bond that is as close as possible to being risk-free. Some benefits of our proposal stem from the first elements, some from the second, and some from the interaction of the two.
Starting with the change in bank regulation, appropriate Basel risk weights and ECB haircuts to sovereign bonds would eliminate the present mispricing of European sovereign bonds. Currently, the riskiest sovereign bonds have artificially high prices (low yields) for at least three reasons. First, because the risk weights according to Basel are zero for all sovereign bonds held by national banks, favoring holding these bonds relative to other risky investments. Second, because in boom phases, banks expect they will be able to pass to the ECB sovereign bonds at generous haircuts during crisis phases. Third, because the contagion provoked by the diabolic loop between sovereigns and banks spreads across borders, creating the expectation that a country will be bailed out by the other European countries. The regulatory changes that we propose would remove these distortions and lead to the correct pricing of the risk associated with sovereign bonds.
This change in regulation would only be fully effective without creating problems of its own if banks had an alternative safe asset to hold. Otherwise, banks would hold the safest European national bonds (e.g., German), amplifying the diabolic country for that particular country and letting adverse shocks to that country’s solvency have a disproportionately large effect on the entire European banking system. This leads to the second benefit from our proposal that comes from jointly changing bank regulation and introducing safe bonds: the shift of bank portfolios from risky sovereign debt to safe ESBies. Banks would still be able to hold national bonds, but only against the appropriate regulatory capital that reflects their risk. Together with the correct pricing of these bonds, this would make it less likely that European banks would risk holding on to a substantial investment for as long as they have on Greek bonds.vi In turn, ESBies would satisfy the demand for safe assets from banks moving away from sovereign bonds. Because ESBies give a claim to the safest portion of the cash flow generated by a well-diversified portfolio of bonds, banks could avoid the overexposure to national bonds that is at the heart of the diabolic loop between sovereign and banking crises.
Third, the existence of ESBies creates a benefit by itself, independent of banking regulation. The EDA would capture some of the “safe haven” premium that investors are willing to pay in exchange for the safety and liquidity of this asset. Currently, Germany obtains some of this premium in tis sovereign bonds, but ESBies would be beneficial on two accounts. First, the extra safety of the ESBies relative to bunds, and the extra liquidity from pooling across European sovereigns, would greatly increase the “safe haven” premium. If the premium were as large as it is for U.S. Treasuries, then the revenues generated by issuing ESBies would be comparable to the revenues that Euro-area countries have obtained in seignorage from the euro. Second, this premium would now be shared with other countries that are as safe but not as liquid, like Austria, Finland, and the Netherlands, and with countries that are not safe at all, like Greece, Ireland, Italy, Portugal and Spain.
A fourth benefit from the ESBies comes from addressing the second problem of the current status quo: the large capital flow imbalances due to the search for “safe haven”. The “flight to quality” would now be a shift out of the junior tranche and into the ESBies, rather than out of one European region and into another. This would stabilize portfolios for sovereign debt, and reduce the sudden reversals of capital flows across Europe and their associated relative-price distortions. With ESBies, the flight to safety across regions is replaced by a flight to safety across tranches.
Fifth, the ECB would benefit by conducting open market operations with ESBies. Conventional monetary policy requires that money be traded for bonds that are safe, and the ESBies would be the closest there is to such an asset. It would still be possible for the ECB to conduct unconventional monetary policy, via "credit policy", in the sense of trading ESBies for other riskier securities. For instance, the ECB could still accept sovereign bonds themselves as collateral, or even the junior tranches of the EDA structure, albeit at large haircuts that properly reflect the risk of these securities. But this would be a policy tool, to use in unconventional times, rather than an inevitable consequence of banks wanting to discount the riskiest bonds at the ECB as they do today.
Sixth, in no part of the proposal does the taxing power of a sovereign over its citizens play a role. The safety of the ESBies is achieved by the triple virtues of diversification, tranching, and credit enhancement. It does not rely on any particular government to extract resources by taxation. Related, there are no fiscal transfers between regions of Europe as a result of the ESBies. Indeed, although ESBies would provide some relief from the sovereign debt woes of Euro-area countries, the EDA will generally buy an amount of sovereign bonds that is well below the total amount issued by the government. As a result, the marginal bond issued would still have to be placed in the private market and be correctly priced. National governments would thus receive the right signals from market prices to provide them the right incentives in managing their public finances.
A seventh, related, advantage is that this proposal requires, to our knowledge, no change to European Treaties. Nothing in the Treaties forbids the creation of ESBies, and the EDA's mission would fall into the broad mandate that was given to the EFSF. The bank regulation revision favoring ESBies would come naturally in a fast-tracked revision of the Basel standards. Finally, the charters of the ECB could be easily modified to encourage it to buy ESBies and stop having to accept all sovereign bonds of member states without violating the spirit of the European Treaties. This is in contrast to Eurobonds, which involve a complicated, multi-year, treaty amendment process.
A final advantage is that, since ESBies would be issued at different maturities, they would generate as a by-product, data on the euro risk-free yield curve. This would be a valuable input for monetary policy and for investors’ risk management that is currently missing in Europe.
The list of all of these virtues may at first seem almost magical. On second thought, it leads to a pertinent question: why hasn't a private bank done the pooling and tranching of sovereign bonds and issued ESBies a long time ago? Answering this question provides an answer to a related important question: how can value be created by just re-packaging bonds? The answer to these questions is that eliminating the distortions brought about by bad regulation creates value. As we discussed earlier, the bank regulation practices of accepting national sovereign bonds as riskless for capital requirements, together with the ECB’s generous haircuts, leads to a mispricing of sovereign bonds. By a government effort, this can be eliminated by directing the ECB interventions and the bank regulation risk weights towards ESBies. Value is thus created by moving to a different equilibrium, one that is supported by a pricing mechanism truly reflective of underlying risks. A private entity could not convince the ECB and the regulators to change their procedures in this way.
A related question is: what if one were to only remove the regulatory distortions in the market for Euro-area sovereign debt, and dispense with ESBies? Several of the advantages above, like the capture of the “safe haven” premium or the attenuation of capital flow imbalances, require ESBies. Moreover, we are doubtful that private financial institutions would create ESBies spontaneously. It is not easy to introduce a large-scale, highly-standardized, issuance program as required by. Private investors may not have the deep pockets to supply a credible credit, the commitment to keep the program going while buyers get used to the new bonds and contracts, or the incentives to be transparent and maximize the safety of the ESBies and its social benefits. A public issuer like the EDA may be more adequate.
HOW TO CHOOSE THE PORTFOLIO WEIGHTS IN THE EDA'S ASSETS?
The ESBies are backed by collateral in the form of a pool of the sovereign bonds of the 17 countries that are members of the Eurozone. A few principles must be followed in the process of picking the amount of each sovereign bond to buy.
The most important principle is that the portfolio choice should be guided by a strict, stable, credible, and transparent rule. The rule should be formulaic and unambiguous, and therefore immune to political interference. Any change should require parliamentary approval and be hard and slow to make. Finally, the rules should also be included in the ESBies contract, so that private holders of the security would have the legal right to demand compensation from the European authorities if the rules were broken, thus endangering the safety of the ESBies. All of these safeguards may seem extreme, but they are inevitable given the events of the past year. In a crisis, there will always be a great temptation for politicians to ask the EDA to increase its bond holdings of a country in distress. Even if this request may seem morally correct, it would undermine the ability of the ESBies to provide a safe security. There are other means by which the European Union may transfer resources to some of its members in need; that is not the function of the ESBies.
We propose that the weights of each bond are equal to the average weight of its sovereign's GDP in overall Eurozone GDP, averaged over the previous 5 years. Figure 3 shows the weights in the collateral pool of ESBies issued today.
Figure 3: Country Weights in the ESBies
This rule is easy to implement and to verify, making its surveillance feasible. It rewards countries that grow faster than average, but only gradually, and the slow-moving weights make sure that ESBies of successive vintages are roughly similar. The dependence is on average past, not present, GDP for two reasons. First, since this avoids a scenario in which a country suffers a terrible shock this year, falls into a recession that requires it to borrow abroad, and finds the EDA having to reduce its holdings of the country's bonds, potentially deepening the crisis. Second, as final GDP numbers are typically only known with some delay, it ensures that governments are not tempted to inflate their provisional estimates of GDP to trick the EDA into buying their bonds.
It is worth discussing two alternatives. The first would be to follow the same weights used by the ECB to determine the allocation of seignorage, and which are based on measures of the amount of money in circulation in each member state. The virtue of this alternative rule is that it is already in use and it has generally proven to be resilient to outside political pressure. Its shortcoming is that a country going through a credit boom will tend to see its measures of broad money rising quickly. Having the EDA buy more of the sovereign bonds in these countries may exacerbate the run up in debt in that country. The other alternative would be to have the weights adjust to measures of risk of each sovereign bond. A benefit of this scheme is that the weights in the portfolio backing the ESBies would serve as an extra mechanism ensuring their safety. There is an important objection, however. If a country's perceived risk increases, this would trigger sales of its bonds by the EDA, raising interest rates and at least partly confirming the initial belief. This leaves room for multiple equilibrium to arise or, more generally, for the EDA's management of its portfolio to amplify shocks in the individual sovereign debt markets. In addition, the risk of a sovereign bond is more difficult to measure and hence can be manipulated.
WHAT MAKES THE ESBies SAFE?
Three features of the ESBies ensure their safety: diversification or pooling, tranching and the credit enhancement. We explain each in turn in this section. By pooling together different bonds, it becomes less likely that all of them default at the same time. Therefore, at any given date, the expected size of the losses in the overall pool is lower. We have conducted some simulations to determine how large this benefit would be. They are available in the appendix; here we briefly describe their main assumptions and the resulting estimates. We consider three possible scenarios facing European sovereign bonds. In the first one there is a catastrophe where all countries in the Euro area have a higher likelihood of default than there has been implicit in prices in the last 20 years, and default in the periphery countries is almost certain. In the second scenario, there is low default risk for all countries except Greece, which is almost sure to default. Finally, the third scenario captures normal times, where conservatively, we assign default probabilities according to each country's current credit rating according to Moody's and S&P. We further assume that the recovery rate to the bondholders is lower in the worse states, and that if some of the larger countries defaults, this will precipitate an almost sure default in their neighboring countries.
Altogether, these assumptions ensure that there is a very large degree of commonality in defaults across the Euro-area. This is likely unrealistic, but in times of crisis, correlations increase quickly, so it is important to be conservative. We then consider two possibilities for assigning probabilities to each of the three scenarios, and to the expected default and recovery rates. In one case, we use the historical data on sovereign bonds between 1983 and 2007. In the second one, we enforce a much more pessimistic outlook on the world to get something closer to a lower bound on the amount of diversification that pooling all of the bonds into the ESBies can achieve. All of these calculations are imperfect and should be seen as a first pass on the problem to provide some rough quantitative guidance of what is at stake.
Under the pessimistic scenario, a simulation of the model predicts that the pool of sovereign bonds will lose 30% of its value with a probability of only 0.80% for every 5-year period. That is, only once every 600 years would the EDA not be able to pay entirely a senior claim on its portfolio of bonds. With the historical-data scenario instead, losses would exceed 30% only 0.11% of the times and they will exceed 20% only 0.50% of the times. Pooling and diversification make ESBies safer than every European sovereign bond in both scenarios.
This leads to the second element that makes ESBies safe. Because they are the senior tranche on the bond portfolio, they are the first to get paid from the revenue of the bonds. Therefore, if the tranching cut-off is 20%, under the historical data the ESBies would deliver a loss only once every 1000 years, while under the pessimistic scenario, the ESBies will pay for sure every 600 years with a 30% tranching threshold. Combining pooling with tranching, ESBies would be considerably safer than German bunds.
We do not want to suggest that this number is the final word. Policymakers can (and should) do more sophisticated calculations considering many alternative scenarios for defaults in the Eurozone to see their implication for the safety of the ESBies. The choice is then how to trade-off keeping the tranching cut-off as low as possible to increase the supply of ESBies for a particular portfolio of bonds, while keeping it as high as possible to keep the default risk on the ESBies low enough to keep them safe.
The safety of the ESBies relies in great part on the riskiness of the junior tranche. We expect that hedge funds, pensions funds and other investors would be willing to hold these securities, at the right price. While an investor can today already buy a portfolio of sovereign bonds, if it wants to leverage this, it must do so on margins that can change every day and induce costly margin calls. The junior tranche instead provides and embedded leverage that is fixed over time. Therefore, an investor today that wants to be exposed to Irish sovereign credit risk can do so indirectly using the junior tranche of the ESBies, without having to borrow and so without committing as many resources. For the radically pessimistic and risk-averse person, we propose a third layer of protection for the ESBies: a capital guarantee. If the losses upon default were to ever exceed the size of the junior tranche, another entity would step in and cover the losses on the outstanding ESBies, with some limit. To be more concrete, the members of the Eurozone could pay in some capital upfront and, in case the default losses exceed the 30% tranching cut-off, these assets would absorb the losses until being exhausted. This guarantee would add to the safety and desirability of the bonds. Since it is effectively catastrophic risk insurance, it would only result bind in the very worst states of the world. How large would this capital guarantee be? In the worst case scenario, where we use our pessimistic parameters, and assume that the EDA purchases 60% of the euro-area's GDP in sovereign bonds issuing the highest possible amount of ESBies, then €800 billion would lower the probability of any loss in the ESBies to 0.2% in every 5-year period. With the historical parameters, a capital guarantee could be much more modest because the first 99.88% of losses would be borne by the junior tranche holders.
The credit enhancement is best provided by a public entity rather than a private source for two reasons. First, if the guarantee were to be provided by a private market party, that party would automatically be too-big-to-fail. The tail risk insurance provided by the guarantee would be hard to price in the private market because of the underlying possibility of a bailout by the authorities. Second, adjusting the size of the capital guarantee vis-a-vis the size of the ESBies tranche gives the power to trade-off the costs of the guarantee in terms of extra protection against the liquidity benefits of being able to issue a larger amount of ESBies. Safety and liquidity are two public benefits of issuing ESBies, that are probably best internalized within public institutions.
The EFSF, created to respond to the current crisis, would be a suitable vehicle to provide this capital guarantee. That is, in the very unlikely event that a spate of defaults across Europe lead to losses above the tranching threshold, the EDA would have the right to call on the EFSF to take up to a certain amount of the losses. Recalling that European countries have already committed €440 billion to the EFSF, this may be feasible. Ideally, the assets would be parked in this vehicle, perhaps using the gold reserves of the countries.vii
Finally, to conclude, it is important to reinforce two points. First, that while the ESBies try to be as safe as possible, not all default risk has been eliminated. European governments will under no circumstance bail out the holders of the ESBies were they to suffer losses after the capital guarantee is exhausted. Second, there is no guarantee whatsoever for the junior tranches. They absorb the first X% of losses when there is a sovereign default in full. Again, in no circumstance would the private market investors holding these tranches (hedge funds, pension funds, etc.), be compensated in case of losses. Unlike the ESBies, these are risky securities.
viA US analogy may be helpful. US banks hold primarily US Treasuries, while municipal bonds are primarily held by private investors. Hence, a default by a state or municipality has much smaller contagion potential.
viiAnother leg of our proposal is the creation of a Euro-wide deposit insurance facility. That would also require some upfront capital, so raising it could be combined with raising capital for the credit enhancement of the ESBies.