European Safe Bonds (ESBies) - (4 of 5)
7. ALTERNATIVES AND ANTECEDANTS
Over the past months, a few proposals have been made to overcome Europe’s problems. In this section, we briefly describe them and explain how ESBies are different. We also discuss some historical antecedents of the ESBies.
7.1. The Difference from the Operations of the EFSF
The EFSF, European Financial Stability Facility, was created in May of 2010 to provide loans to euro-area countries in trouble. It funds these by issuing its own bonds, guaranteed by all of the member states. We can reinterpret these actions as buying sovereign bonds and issuing its own bond, which has some similarities to the ESBies.
However, there are many crucial differences. First, the bonds issued by the EFSF are not each tightly linked to a portfolio of sovereign bonds. While the facility holds as assets sovereign bonds, it can change the composition of bonds it holds at any time without approval of its creditors. Second, the bonds issued by the EFSF are backed by the sovereign states and their taxing power over their citizens. While the states keep to this commitment, there is no equivalent of the junior tranche in our proposal to absorb any losses from default in the sovereign bonds. It will be the taxpayers of these countries that must shoulder any losses. If the states waver in this commitment, then the bonds issued by the EFSF will only be safe as long as the political circumstances are behind them. Third, and perhaps more crucially, the sovereign bonds held by the EFSF are, by design, the ones with the highest credit risk. Because the default of one of the countries in trouble would likely precipitate the default of another, there is almost no diversification achieved in this portfolio. In contrast, the ESBies are backed by a diversified pool of sovereign bonds, are relatively immune to political pressure and hesitations, and are made safe by using financial engineering—pooling, tranching, and capital guarantees—rather than by imposing a fiscal union on unwilling taxpayers.
7.2. The Difference from Eurobonds
Eurobonds are bonds backed with solidarity by all of the member states. This would imply that if a bond was issued to finance a project in Portugal, in case the Portuguese state is unable to pay, it will be up to the other taxpayers in the euro-area to pay off the debt. Like ESBies, Eurobonds have the potential to become a safe asset by diversifying across sovereign states.
The main difference is that, unlike ESBies, Eurobonds involve “joint and several” guarantees, in which all parties are guarantors of the obligations of each of the other parties. As a result, Eurobonds require tight fiscal policy coordination among Eurozone member states, or they are subject to moral hazard as one member state runs up debts that it knows the others will partly for. With ESBies, the guarantee is provided by the pool of bonds, not by any future fiscal revenues. The joint and several guarantees would require a significant revision of European treaties and are opposed by a very large part of the European population.
Second, ESBies would in principle be safer than Eurobonds. Whereas the guiding principle behind a Eurobond is fiscal solidarity, the guiding principle behind ESBies is safety. There would always be some uncertainty that some member states would refuse to tax their citizens to pay these bonds if they perceived that they were unfairly heavily transferring funds to another rogue state. With ESBies, there is no such uncertainty, as political will is removed from the equation.
Third and related, recent research has identified the “safe haven” premium of U.S. Treasuries as being more due to their covariance structure with other assets rather than with the size of outstanding bonds. Eurobonds and ESBies could be similar in size, but ESBies are designed to be safer and so would capture the bulk of the elusive liquidity premium that is often put forward to support Eurobonds, but which Eurobonds may not get. Fourth, ESBies are created together with a junior tranche. This brings the benefit that capital in “flight to quality” can shift between two Euro-zone securities during times of crisis, without leading to sudden shifts in the capital flows to a particular region. Eurobonds instead, have no risky counterpart.
Fourth, there is a hard limit on the amount of circulating ESBies, both in its rules as well as automatically by the availability of enough sovereign bonds with low default risk. With Eurobonds, instead, each country has a great incentive to issue many bonds and have others pay for them. Fifth, and related, with Eurobonds individual countries lose the market signal on their fiscal accounts. Without national sovereign bonds, there are no country-specific bond prices to discipline fiscal policy in individual countries. For a small country, the effect on interest rates of issuing much more debt than it can pay may be negligible.
7.3. The Difference from Blue–Red Bonds
The Brueghel institute (Depla and Weizsacker, 2011) proposes a refinement of Eurobonds that addresses the last two criticisms. Blue Eurobonds with joint guarantees would be issued only up to 60% of the Euro-zone GDP. Any additional (red) bonds would have to be issued by the sovereign, for which it would be entirely responsible as there would be a strict no bailout clause to any red bond. The interest rate on the red bonds, which would be the marginal bonds issued by a sovereign, would be priced correctly and give the appropriate signals to fiscal authorities.
At the same time, blue bonds would still suffer from serious shortcoming relative to ESBies. They involve a joint guarantee, with its coordination and political problems, and they would still be less safe than the ESBies insofar as the joint guarantee that Euro-area countries for blue bonds is not completely credible.
7.4. The Difference from Synthetic Eurobonds
As we were finalizing our own proposal, Beck, Uhlig and Waner (2011) suggested in an opinion piece the creation of “synthetic Eurobonds”, which have many resemblances with our ESBies. They also noted that it was important to solve the crisis to create a euro-wide bond that European banks and the ECB could hold. They envision the creation of a European debt mutual fund that issues synthetic Eurobonds against a pool of sovereign bonds and reaps the benefits of diversification, just like the ESBies.
Our proposal goes further than theirs. On top of diversification, we add tranching and potentially the capital guarantee in order to make the ESBies truly safe. The focus of the ESBies is not to create a Euro-wide security per se, but to create a safe security. The synthetic Eurobonds are a portfolio that includes both the ESBies and the junior tranche in our proposal. They are much less safe than the ESBies. Finally, we envision the EDA as being immune from political pressure, and the sovereigns as continuing to issue sovereign debt alongside the ESBies, and have provided much detail in the previous sections on how to design the system to achieve these goals. In sum, the ESBies share he same starting point as the synthetic Eurobonds but go much further.
7.4. The Difference from Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are two U.S. institutions that buy mortgage bonds, pool them, and sell securities backed by these mortgages to other investors. Given that the two institutions had to be bailed out by the U.S. government, does the same fate await the EDA?
Not at all. The key difference between Fannie and Freddie’s structure and the EDA is that Freddie and Fannie assumed all the default risk on the underlying mortgages, issuing mortgage-backed securities that only contained interest rate risk. While Freddie and Fannie charged a price for the default risk they took on, its price was woefully inadequate because of the implicit government backing it received. That same government backing also induced it to take riskier mortgages onto its own balance sheet. The EDA has none of these design flaws. It would issue junior bonds that would bear virtually all the default risk on the underlying sovereign bonds. Its portfolio weights would be formulaic and immune to political pressure. Freddie and Fannie had private shareholders, pushing it to take on more credit risk onto its balance sheet and to compete aggressively with other private mortgage market players. The EDA instead has public shareholders, and similar to multilateral agencies like the ECB or the IMF, a clear mandate to produce the safest bond possible. There is a hard limit on the total issuance of ESBies, and the holders of the junior tranche have absolutely no control rights over the EDAs actions.
7.4. The Difference from Private CDOs
The ESBies are collateralized debt obligations (CDOs). Given that a part of the financial crisis of the last few years was the break down of debt securitization, we must avoid the mistakes of the past.
First, whereas the issuers of private CDOs in the US were private banks who, in some cases, appear to have manipulated the content of the contract to favor some clients, the EDA is a public multilateral institution. The EDA’s incentives should be aligned with those of the public, and these are several extra checks and balances in our proposal to ensure this is the case.
Second, the portfolio weights of the sovereign bonds are fixed ex ante (equal to GDP) shares, and there is no scope for the issuer to manipulate them. The ESBies are transparent and have rules that are easy to monitor, whereas the private CDOs leading to the crisis were opaque. Along the same lines, there are only two tranches in our proposal, ESBies and junior tranche, whereas many of the problems with the CDOs had to do with their multiple intermediate tranches and further rounds of repackaging.
Third, there are will be a separate market for each of the component securities of the ESBIES, where prices can be observed and where the right incentives will be preserved. This was not the case in the case of CDOs, which often were the only vehicle through which investors could access some specific assets, like particular mortgages.
This proposal is a first step both towards solving he current sovereign crisis, and towards building a sustainable institutional framework for the Euro. In the short run, by allowing all European countries to reenter the capital markets, it will slowly reduce the panic that is currently griping the market. Moreover, by substantially reducing the risk of contagion between banks and sovereigns, and the apocalyptic scenarios where the EMU project collapses, the ESBies will contribute substantially to stabilizing markets.
In the long run, by correcting the regulatory errors that were at the origin of the crisis, the proposal lays the foundations for a stronger Euro Zone in the long run. The current problems may not have arisen without the Basel 0-risk weight for sovereign bonds. Prices will recover their informational function and will allow the market to make capital allocation decisions taking into account the proper risks.
In our view, two more elements are necessary to stabilize the shaky foundations of the Euro. First, some sovereigns are undoubtedly insolvent. A credible, orderly, bankruptcy procedure for sovereigns that minimizes the risk of contagion is needed. Second, the financial system of the Eurozone is too fragile and contains too many systemically risky institutions. A Eurozone-wide banking resolution regime, able to prevent contagion and protect European depositors, must be put in place. In the next few weeks, we will make concrete proposals in this direction.