5 min read 12 Mar 18
Summary: Creating a Eurozone-wide safe asset and thus diversifying sovereign risk within the currency union without the need for sovereign debt mutualisation – sounds like having your cake and eating it, doesn’t it? Well, according to the European Systemic Risk Board (ESRB), sovereign bond-backed securities (SBBS) might do the trick. SBBS are merely an idea, discussed in ESRB working papers, feasibility studies and seminar presentations, but one day they might become reality.
Just like more traditional asset-backed securities, SBBS would combine two key features: pooling of assets and tranching of risk. The SBBS-issuing entity keeps a cover pool of government bonds as assets on its balance sheet. For the sake of simplicity and transparency, it might be beneficial to only include EUR-denominated central government bonds of Eurozone member states in the pool, using the ECB capital key to determine the portfolio weights. Minor deviations could however be made in order to account for member states with small amounts of outstanding debt or to allow for the inclusion of bonds from non-Eurozone EU member states, which would enhance diversification.
The cover pool is used to back on the liability side the issuance of SBBS, which are claims on the underlying sovereign bond portfolio. Financial engineering is applied to create a contractual seniority structure consisting of three distinct tranches: senior, mezzanine and junior. A cash flow waterfall defines the priority of payments so that any non-payment on bonds in the cover pool is first borne by junior SBBS holders. Only after the junior tranche is exhausted, further losses would be imposed on mezzanine SBBS holders and so on. Senior SBBS, sometimes referred to as European Safe Bonds (ESBies), are thus protected by the loss-absorbing nature of the subordinated tranches. According to the ESRB feasibility study, a 70% thick senior SBBS would have risk characteristics at least as strong as lower-risk Eurozone government bonds. A 20% thick mezzanine SBBS would behave similarly to lower investment grade sovereign bonds, whereas a 10% thick junior SBBS would be much riskier and comparable to higher-risk Eurozone government bonds.
Importantly, the SBBS-issuing entity is simply a pass-through vehicle, i.e., cash flows accruing from the cover pool are merely passed on to SBBS investors. Claims of investors are limited to the assets secured in their favour. The SBBS-issuing entity itself is bankruptcy-remote.
The emergence of senior SBBS as a Eurozone-wide low-risk asset would have two main advantages.
No, I wouldn’t expect an implementation in the near future. There are considerable hurdles that would need to be cleared first, in particular the following two.
SBBS would certainly offer a number of desirable features – both from an investor’s view point and with regards to financial stability within the Eurozone. They might have the potential to ultimately become a mainstream asset class. The ESRB reckons that over time the SBBS market could reach volumes of €1.5 trillion or more. It’s not going to be a quick win, though.
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