The securitization of European government debt

Benjamin Wilhelm (Uni Giessen) and Andrea Lagna just published the following piece in SPERI Comment.

Recently, European policymakers and representatives of financial institutions met in Paris at a workshop organised by the European Systemic Risk Board, the body which is responsible for the macroprudential oversight of the EU financial system.  They discussed the creation of sovereign bond-backed securities as a solution to the scarcity of safe assets in Europe.

We argue that this proposal to securitize government bonds fails to tackle what we see as the fundamental problem of the Eurozone: the absence of a political union with a common fiscal policy and government bond market.  In times of political-economic distress across the European continent, the securitization of government bonds may even exacerbate conflicts between highly-rated and low-rated sovereign states.  As an alternative, and set against the perils of market-based financial innovation, we believe that policymakers should be starting a necessary and serious debate about how to implement Eurobonds.  This simple but effective instrument would be an expression of fiscal solidarity and would help to foster a shared European federal democratic politics.

 

The strange case of safe assets in Europe

Regulators have treated the sovereign bonds of all Eurozone members as equally safe.  However, European government bonds have different credit ratings and show dissimilar pricing dynamics in the market for credit default swaps.  In other words, this means that some bonds (e.g. German Bunds) are safer than others (e.g. Italian BTPs).  According to an informal group of economists known as Euro-nomics (see two of their analyses here and here), this odd situation in European sovereign bond markets has generated two problems.

First, European banks hold large amounts of their respective national debt rather than diversifying their portfolios.  For instance, Italian banks bought a lot of Italian government bonds.  This is the infamous sovereign-bank nexus, the consequences of which coalesce into a 'diabolic loop'.  In the event of a sovereign debt crisis, investors expect the risk of bank insolvency to increase because banks hold too much sovereign debt.  At the same time, investors speculate about governments having to rescue their banking systems.  As a result of such governmental intervention, investors start to question the sustainability of public finances and ultimately see sovereign bonds as a risky investment. 

Second, stronger European economies experience capital inflows in times of crisis and outflows during times of economic growth.  In other words, there is a flight to safety to the bonds of core member states during critical periods and vice versa.  These swinging flows create capital account imbalances in the Eurozone, subtracting resources at critical moments from the peripheral countries that need such resources the most.

 

Sovereign bond-backed securities

To solve these two problems, Euro-nomics researchers propose the creation of a European Debt Agency (EDA) to be in charge of managing the securitization of government bonds from European member states.  A new EDA would create what they call ‘European Safe Bonds’ (ESBies) – a different name for sovereign bond-backed securities.

In brief, the system they propose would see the EDA buy sovereign bonds of member states according to some fixed weights.  It would passively hold European sovereign bonds as assets in its balance sheet and use these underlying bonds as collateral to issue two securities:

  • The first security would give the right to a senior claim to the payments from the government bonds which are included in the pool.  This is a safe asset and the European Central Bank could use it as collateral in its open-market operations.  Moreover, financial regulators would weigh this safe tranche – but not the underlying sovereign bonds – as bearing zero-risk weight
  • The second security is made of the junior tranche on the portfolio of bonds.  This is a risky security and any loss deriving from a government debt default would be absorbed by risk-taking investors.

To summarise, the Euro-nomics economists argue that the creation of ESBies would provide a European safe asset, although in a ‘synthetic’ form.  European banks would still be allowed to hold national government bonds, but these would now be considered risky to different degrees.  Thus, banks would think twice before accumulating too much sovereign bonds, giving that they would have to balance their assets with enough banking capital.  With banks reducing their exposure to government debt bonds, the sovereign-bank nexus would disappear.  

 

Eurobonds and fiscal solidarity

Creating a synthetic security of underlying government bonds is a clever and creative exercise of financial engineering.  Unfortunately, it would do nothing to address the political and economic divisions that afflict Europe.  At worst, the securitization of European government bonds – by pushing for regulators to weigh the underlying bonds of member states differently – would add fuel to fire and intensify hierarchies in the Eurozone.

Political leaders and key policymakers are likely to welcome sovereign bond-backed securities as a powerful device to muddle through the Eurozone crisis.  We believe this is the wrong path to follow.

It is time to stop kicking the can down the road and finally confront the creation of a political and fiscal union.  Eurobonds – that is, the full substitution of the current system whereby each Eurozone member issues its own bonds with a single European issuing process – contain the seeds of a common path to fiscal solidarity and eventually a shared political project.  To be sure, there are numerous difficulties with regard to the legal and institutional challenges of implementing Eurobonds.  However, we should debate these aspects rather than circumvent them by resorting to securitization.

Euro-nomics researchers contend that ‘many Europeans are not willing to accept the fiscal integration required by Eurobonds.’  Besides being inaccurate, this assumption serves the only purpose of preserving the technocratic and neoliberal status quo of present-day Europe.  At the start of another year where European policymakers will continue to address the unresolved Eurozone crisis, Eurobonds represent a vital alternative to the dangerous idea of sovereign bond-backed securities.