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`Safe Bonds' Are Not So Safe After All

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Call it the Holy Grail of the euro zone. Ever since the financial crisis, economists have been seeking ways to create a safe financial instrument, which banks in the single currency area can buy without having to load up on domestic sovereign bonds. Many placed their hopes in the proposal of a bundle of sovereign bonds called “European Safe Bonds” (ESBies); but that looks set to disappoint.

The purpose of a European “safe asset” is to dismantle the so-called doom loop between lenders and governments. Many euro zone banks hold large portfolios of domestic government bonds. When a sovereign gets into trouble, as happened to Greece and -to a lesser extent -Italy during the euro zone crisis, investors start doubting the value of these holdings. As a result, a sovereign debt crisis can quickly produce a banking crisis too. In fact, the sovereign debt crisis may be exacerbated, since investors may fear that the government will need to bail out its banks.

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Of course, banks do need sovereign bonds: They are liquid assets, which can be sold quickly when needed. They can also be used as collateral by a central bank to obtain liquidity. So economists are seeking ways to design a financial instrument which is not tied to an individual euro zone country. The constraint here is that the new security should involve no sharing of debt, or debt mutualization, an idea which Germany and other low-debt countries are vehemently opposed to. They fear that they would be responsible for standing by weaker member states such as Italy or Portugal, were they to default.

A group of economists working together with the European Systemic Risk Board, the body looking after the overall financial stability of the EU, seemed to have been successful in this quest. The “European Safe Bonds”, presented in January after a long academic gestation, would combine all euro-zone sovereign bonds into one asset. They have the attractive feature of allowing investors to diversify risk. But, on closer scrutiny, they aren’t as safe as they seem: ESBies could end up inducing the very crises they seek to avoid.

The ESRB proposal suggests that government bonds would be packaged together according to weights dictated by the ECB’s capital key. This determines how much capital each country should contribute towards the ECB. They would then be filleted in three parts: A supposedly safe one (the ESBies) — which would be bought by the likes of pension funds — and then a mezzanine and a junior tranche, which could be acquired by hedge funds. Were a country to default, the junior tranche would be the first one to suffer losses. If this were not enough, safer portions would also be affected.

The design of this instrument is clever. Its adoption, however, depends crucially on the way regulators treat it. At the moment, ESBies would be treated for risk purposes like a securitized product, the murky financial instruments such as mortgage-backed securities which contributed to the financial crisis. Banks find these securities costly, because of the amount of capital needed to hold against them. Supporters of ESBies would like regulators to be less stringent, arguing that sovereign bonds are a lot safer than, say, auto loans or mortgages.

However, even this may not be enough: At the moment, individual sovereign bonds are considered perfectly safe and hence enjoy a “zero-risk weight” when determining how much capital banks should hold against them. So long as this preferential treatment exists, lenders will have no incentive to hold ESBies over their own government debt, since this would force them to hold an extra layer of equity. The only way for ESBies to fly would be to give them a zero risk-weight, while removing it from individual sovereign bonds.

Some would argue this would be only fair: since ESBies are a diversified asset, they should be treated more favorably than country-specific sovereign bonds. The trouble is that the kind of diversification offered by these instruments is much lower than initially thought. While there are 19 countries in the euro zone, the weight of the top five or six countries within the bonds would be overwhelming. If Italy or France were to go bust, the presence of Latvian bonds in the security would offer little protection. Furthermore, as the euro zone crisis showed, sovereign bonds can be highly correlated: Once a country such as Italy suffers from a shock, Spain, Portugal and Greece are likely to come under pressure too. Even the “safe” ESBies can’t protect investors from contagion.

Then there are big issues of implementation. The first is cost. In theory, ESBies could be provided by banks or asset managers, who would buy sovereign bonds in individual auctions and then package them. This would clearly come at a price, which would make these securities more expensive for investors than national debt. Moreover, these instruments would be highly illiquid, at least to begin with. Banks would demand a premium to hold them.

The second implementation problem is that, during a time of stress, securitization could propagate, rather than avoid, a crisis. Were a euro-zone country to be at risk of default, it is easy to imagine that no-one would be willing to buy the junior tranche of the securities. As a result, it would be impossible to issue them; the market would freeze and, possibly, collapse. This process could also accelerate contagion, spreading the fire to bonds which are considered safe.

So far, the assessment of rating agencies has not been positive. Standard & Poor’s issued a preliminary note on ESBies, indicating an approach that would rate them well below AAA. Proponents of ESBies think this is due to S&P’s own idiosyncratic methodology, which assumes there is zero recovery in case of losses. However, the rating agency’s criticism that there would be an excessive correlation of risks between the underlying sovereign bonds still stands.

Regulators are right to want to ensure that banks aren’t loading up on government debt, leaving both vulnerable. But for all the good intentions of economists, there may be no easy way to create a safe asset which does not entail the sharing of risks between sovereign governments: Germany being on the hook for at least some of Italy’s debt, and vice versa. A true “safe asset,” I fear will have to wait until the euro zone is prepared to accept mutual responsibility for sovereign debt. Regrettably, we are still a long way from that now.

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Ferdinando Giugliano

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.