EUROZONE REFORMERS ACT AS IF THE CRISIS NEVER HAPPENED / THE FINANCIAL TIMES COMMENT & ANALYSIS

Eurozone reformers act as if the crisis never happened

Safe bonds are a bad idea whose time has definitely not come

Wolfgang Münchau


Financial instruments: The European Central Bank in Frankfurt, Germany © Bloomberg


Here is a recipe for disaster. You start off by taking the two most toxic financial instruments of the past 20 years, and then merge them. The first is the collateralised debt obligation, the complex instrument at the heart of the US subprime crisis a decade ago. The financial sector created a housing boom through a relaxation of lending standards, transformed the mortgages into complex CDOs, and then sold them off to unsuspecting investors.

Next, you take a much more innocent-looking instrument: a sovereign bond from a eurozone country. They are actually risky assets because eurozone countries issue sovereign debt but no longer have their own autonomous central bank as a buyer of last resort. This is why the eurozone debt markets are inherently more crisis-prone than those of countries with an independent monetary policy.

As a next step, you mix these two very different instruments according to the following instructions: you take government bonds of all or some of the eurozone members and turn them into a CDO. You call them European Safe Bonds — or ESBies. ESBies are European.

They are safe because it says so on the label. And they are bonds. So what is not to like?

For starters, the CDO scam of the subprime years critically relied on collusion from rating agencies, and the rating agencies have learnt their lesson. The high ratings they used to give to CDOs were based on a misjudgment, deliberate or otherwise, on the nature of the risk. A single housing loan can always go bad. In good times, such a risk can be neutralised. But if the entire housing market crashes, many loans go bad at the same time.

Risk correlation was also a big problem for sovereign bonds during the eurozone crisis. The two situations are therefore comparable. Standard & Poor’s said last year that it would rate ESBies in the lower half of the investment-grade spectrum.

One would have assumed that alone would have killed the idea. But a version of the ESBies has made a surprise comeback in a recent paper by a group of French and German economists, who set out to bridge their countries’ differing views on how to reform the eurozone. One gets the sense that the authors’ knowledge of the academic financial market literature exceeds their knowledge of the reality of financial markets.

One particular section of the document reads as though the subprime crisis never happened: “‘Safety’ is achieved by some combination of diversification and seniority. In the . . . most developed proposal, financial intermediaries would purchase a standardised portfolio of sovereign bonds . . . and use this collateral for a security issued in several tranches. The “subordination level” . . . could be calibrated so that the five-year expected loss of the most senior tranche . . . is about the same as that of an AAA-rated sovereign bond.”

ESBies have another, more serious problem. They cannot take over the collateral function of ordinary government bonds. Modern economies need large volumes of safe assets to grease the huge volumes of daily money market transactions. Safe assets are used as collateral in so-called repurchase agreements, or repos, one of the largest sections of the money market.

From a purely financial perspective, the eurozone crisis started with a realisation among investors that the bonds of the peripheral eurozone countries were not safe. The crisis ended when Mario Draghi, president of the European Central Bank, gave an unlimited pledge to buy “whatever it takes”. This was followed a few years later by actual purchases of government debt. As a byproduct of the ECB asset purchase programme, the eurozone gained a safe asset in virtual form.

As of the end of January, the ECB held €2.3tn in assets from its purchases of government bonds. The purchases are likely to be phased out this year, but for as long as the ECB maintains the existing stock, the eurozone already has a rock-solid, albeit synthetic, eurobond.

The bonds held by the ECB constitute an available pool of assets to be used as collateral for repos.

To avoid a potential collateral squeeze, the ECB has become the critical player in maintaining an orderly repo market. If the ECB were to switch from buying assets to selling assets, and wind down the actual stock of government bonds, the eurozone would then have to rely on national bonds or synthetic ESBies for financial stability. Good luck with that!

Not much harm would be done if the eurozone states created ESBies as some kind of public relations exercise, as a token symbol of their togetherness. This is all fine for as long as the ECB does the heavy lifting. But it does not take much imagination to come up with a scenario where that might no longer the case.