Europe's Sovereign Bond-Backed Securities

|
Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EUFL, EUFN, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, GSEU, HEDJ, HEZU, HFXE, IEUR, IEV, PTEU, RFEU, SBEU, TAUX, UPV, VGK
by: Marc Chandler
Summary

EC proposes private sector create securities backed by EMU sovereign bonds.

Immediate reception by Germany and Fitch was quite cool.

New product could help banks break the doom link with their own sovereign.

It has been discussed for several weeks, and today the European Commission unveiled a proposal for a new asset-backed security. The backing would be sovereign bonds weighted by the size of the economy.

This may sound like mutualization of risk, but it is no such thing. These new securities are not Eurobonds. The EC is calling on the private sector to bundle existing sovereign bonds, and issue asset-backed securities with different tranches to provide gradations of risk. The sovereign bond-backed securities (SBBS) will not be available anytime soon. National governments need to approve appropriate legislation, but the signal from the EC is that the SBBS should be treated in the same way as national sovereign bonds rather than securitized products.

The EC is proposing what the private sector should do. It is taking no risk itself. The success depends on the take-up by investors and banks. Fitch is skeptical. It does not see how re-packaging sovereign bonds reduces risk. It also does not see the SBBS supplanting German Bunds as the benchmark.

Many investors may not like these new instruments. There are no state guarantees. They will likely be assigned lower credit ratings than the highest rated members and have less liquidity. Germany has come out in opposition, claiming it creates new risks.

The best fit may be for European banks. The SBBS may help loosen the relationship (doom-loop) between banks than their sovereign. In the recent past, a banking crisis became often morphed into a sovereign crisis, public funds were drawn upon. In Europe, this is more difficult since the Bank Recovery and Resolution Directive ((BRRD), approved 2014).

The causation arrow also can go the other way. Domestic banks are often substantial holders of their sovereign bonds. A sell-off of those sovereign bonds could weaken the health of the banks. The SBBS would help the link by facilitating the diversification of sovereign bond holdings. It could help break the overwhelming element of home bias.

ECB member Lane from Ireland, who is tipped to possibly succeed Praet as the central bank's economist, headed a commission at the European Systemic Risk Board that led to the SBBS proposal. He suggested that the senior tranches of the SBBS could potentially be accepted by the ECB as collateral, but the central bank technically cannot take on credit risk.

Some observers (like European Professor Claeys who shared his critic on Vox) argue that the SBBS is unnecessary and a distraction. The SBBS does not bring the EMU closer to completing monetary union or banking union. There are no shortcuts to the necessary national and institutional reforms. In the best of worlds, the criticism seems valid, but in the second or third best world that we occupy, there may be a legitimate use for SBBS. It need not be much of a distraction from reforms, which ECB President Draghi frequently complains are insufficient.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.