ECB’s New Plan B? Synthetic Structured Eurobonds

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“Near-zero risk” derivatives… the banks are on board.
By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.
We could be about to be treated to a brand new central bank-coined acronym, ESB, or in its somewhat catchier plural form ESBies (as in “esbies”). ESB stands for “European Safe Bond,” which in today’s Europe may sound like a contradiction in terms but is in fact an idea that has been gathering dust on the drawing board for close to seven years. It could soon be brought to life, however, if the ECB approves a plan being drawn up to launch the new financial instrument by an independent task force under Irish central bank governor Philip Lane.
Here’s how the scheme would work: private or public institutions, such as large banks or the European Stability Mechanism — the euro zone’s bailout fund — would repackage sovereign debt from the Eurozone’s 19 nations into three tranches: a senior tranche that would have a credit rating of AAA or thereabouts, a junior tranche that would be rated lower but would still be investment grade, and the lowest level which would contain the riskiest securities, might be below investment grade (“junk” rated), and would yield around 5-6%.
Essentially the securities would be derivatives — based on sovereign bonds.
The basic goal behind the plan is to diversify public debt risk in the Eurozone so that it will be able to withstand default by one or more countries without sparking contagion throughout the system, one of the members of the task force told Bloomberg. It’s also hoped that ESBies would partially fulfill the role of Eurobonds, but without the joint and several liability that would demand treaty changes.
The European Commission would need to publish a regulation to allow ESBies to receive the same regulatory treatment as sovereign debt, the person told Bloomberg.
Naturally, there is a danger that trying to solve the Eurozone’s chronic structural problems with even more extreme forms of financial engineering could end up backfiring. Lest we forget, it was the mass securitization of subprime mortgages that hugely magnified the contagion effect of their eventual collapse in 2007-08. As a new paper by leading economists from France and Germany warns, the introduction of ESBies could carry the risk of similar unintended consequences, including the possibility of a mass selloff of the lower-rated tranches in times of crisis.
There are also concerns in some northern capitals that ESBies could serve as a halfway house to full-on debt mutualisation in the Eurozone, raising fears that they would end up paying for others’ debt through the back door or even bailing out the ESB issuer in case of market stress. To allay such fears, Phillip Lane said the issuing entity would have to follow strict guidelines and be shielded from political interference.
“These sovereign bond-backed securities are issued by a robot,” the Irish central bank governor said in Helsinki. “There is no possibility for anyone to interfere with the robot.” Seriously, that’s what he said.

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Banks Already on Board

Unsurprisingly, European banks have already expressed a keen interest in ESBies, according to Bloomberg:

The securities could be a new liquid “near zero-risk asset” that serves as an alternative to sovereign bonds, the heads of Europe’s biggest lenders said in a recent document seen by Bloomberg. Banking regulators are considering whether to impose limits on banks’ holdings of sovereign bonds and increase the capital they have to put aside to cover their exposure.

In other words, the timing could not be better. And not just for Europe’s banks. One major consequence (presumably unintended) of the ECB’s almost €2 trillion sovereign bond buying program is that it has spawned a culture of financial dependency among some Eurozone governments, in particular those with high levels of public debt like France, Spain, Italy, Belgium and Austria. And now, as the ECB tries to ween them off its QE program, those countries could begin suffering severe withdrawal symptoms as the price of their bonds falls and yields rise.
A new study by the German economist Friedrich Heinemann of the Centre for European Economic Research (ZEW) in Mannheim has shown that the more the ECB pares back its asset purchases, the more of what remains is being used to support heavily debt laden economies like Italy. “The ECB’s bond-buying program is increasingly asymmetrical,” said Heinemann. “More and more, the ECB is buying the bonds of the heavily indebted euro states.”

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Exiting a Catch 22

In 2015, when the ECB launched its QE program, the concentration of sovereign bond purchases was supposed to reflect the amount of capital each Member State’s central bank contributes to the ECB’s coffers — what’s commonly referred to as its “capital key.” But in recent months the bond purchases have been increasingly skewed toward more indebted countries.
The study found that the share of government bonds from Spain, France, Italy, Belgium and Austria in the 2015 purchases was 59%. In 2017, it would reach about 63%, the study says — well above the ECB’s capital key of 58.2% for those counties and their total share of Eurozone GDP of 54.4%.
The ECB now faces a Catch-22, Heidemann says. On the one hand, the dependence of some national governments on bond purchases has become very high, which could rule out a quick exit of QE. On the other hand, the longer the program goes on, the worse this dependency will become.
And that is where ESBies could come in handy, by essentially providing the ECB with a means of continuing to taper its QE program without visiting untold damage on weak, heavily dependent economies like Italy’s or Spain’s. The new instruments might even provide the ECB with a way of gradually liquidating the massive sovereign bond exposures — more than €1.9 trillion so far — accumulated in its QE program, if it all works out according to plan and nothing breaks. By Don Quijones.


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