New Euro area safe bonds: High risks for the ECB

An EU working group presented yesterday a feasibility study for sovereign bond-backed securities. These bonds are designed to reduce the vulnerability of the European banking sector to sovereign debt crises. The problem, however: Should there be any disruptions in the markets for these securities in the event of a crisis, the European Central Bank (ECB) would have to step in.

One of the biggest weaknesses of the European monetary union is the lack of safe assets. In the latest sovereign debt crisis, this triggered a flight into German government bonds, which investors regard as a safe haven asset. Due to the capital withdrawals in the crisis countries, their banks came under massive pressure. The Sovereign Bond-Backed Securities (SBBS) are designed as bonds with three risk classes: from safe to high-risk. The SBBS are based on government bonds of the euro member states - that is, a special purpose vehicle buys the government bonds and finances them by issuing the SBBS. In the case of default by one country, the buyers of the safe tranche are served first, while the buyers of the other two tranches bear the losses.

Especially the high-risk class of the junior bonds poses a problem. The junior bonds should appeal to risk-tolerant investors outside the banking sector, because their losses would be less threatening in the case of a sovereign debt crisis. However, it is overlooked that these investors will sell-off their bonds in a crisis, so that the risk premiums for junior bonds will skyrocket. This could also trigger the banks holding the safe senior tranche to get nervous and lose confidence in the senior tranche. This could jeopardize the entire SBBS concept: if no junior bonds are bought on the primary market, the entire market for sovereign bond-backed securities would collapse.

However, since this market is systemically important, the ECB would have to step in as a buyer of last resort in the event of a crisis. It would have to buy the risky junior bonds on the primary market to guarantee the smooth functioning of the SBBS market. In case of possible losses, there would then be a mutualisation of public debt through the back door.