European Union leaders continue to contort themselves to find a way to issue common bonds in the face of Germany’s obstinate refusal of any measure that could put the country’s taxpayers on the hook for another country’s debt.
Several centuries ago, it was an issue the nascent United States solved in four months when Treasury Secretary Alexander Hamilton pressured states to allow the federal government to assume their debts and issue bonds for them. The holdout then was debt-free Virginia, which, like Germany, didn’t want to have to pay for the debts of less-disciplined states
Hamilton won Virginia’s approval in the Compromise of 1790 (“the room where it happenedâ€) by agreeing to locate the federal capital on the Potomac in exchange.
The latest EU effort to come up with with a bond that overcomes Germany’s reluctance and provides some semblance of a common euro bond is sovereign bond-backed securities – SBBS, for short.
The securities, structured like the ill-fated collateralized debt obligations, provide different tranches categorized by safety – notably a highly-rated tranche for low-risk investors packaging the bonds of fiscally sound countries like Germany, and a lower-rated tranche of speculative bonds from riskier countries around the Mediterranean rim.
Political delays
The scheme, first proposed last year, was debated by the European Parliament earlier this month, but few expect any significant movement before a new European Commission takes over in Brussels in November.
The problem is that the SBBS scheme doesn’t solve any of the issues it’s intended for. The biggest is a shortage of highly-rated sovereign bonds for collateralOpens a new window  since Germany persists in running a balanced budget, along with other top-rated countries like the Netherlands, which means they’re issuing few bonds.
Since SBBS would pool bonds according the relative GDP share of countries, this could strictly limit the volumeOpens a new window that could be issued.
In addition, there’a no guarantee that banks would be happy to switch their investment policy from German government bonds to the more complex SBBS unless regulatory treatment – the amount of capital required to be held against these assets – was changed to favor significantly the euro area bond.
Structural flaw
By adopting the flawed structure of a CDO, the proposed euro bonds would be prone to the same fate of spreading risk rather than containing it in a crisis. The experience in the financial crisis was that the tranche structure, far from fortifying the weaker collateral with the stronger, led to pancaking as the bonds collapsed in value.
Any safeguards to prevent such a fate would leave markets where they are now: quick to exclude weaker countries in a crisis, which would aggravate the problem rather than solve it.
One of the main objectives of the SBBS scheme is to break the so-called “doom loop†between government debt and a country’s banks as the latter load up on sovereign bonds to take advantage of favorable capital requirements.
The resulting risk is that problems at a particular bank could cast doubt on the creditworthiness of the country’s bonds, while a country’s over-indebtedness could threaten the value of sovereign bonds held by its banks. Pooling the debt in SBBS would make banks investing in them perhaps less vulnerable to their country’s fiscal problems.
Weakening the doom loop
This is one of the points made by European Commission vice-president Valdis Dombrovkis when he launched the European Parliament debateOpens a new window in mid-April.
“They could in fact boost private sector risk sharing, especially across borders, and equip banks with an additional tool to diversify their sovereign exposures,†Dombrovkis said of SBBS. “This would further weaken the nexus between banks and their own sovereign – which proved a major source of vulnerability in the euro area debt crisis.â€
But none of this settles what happens when a troubled country is excluded from new issues and its problems impact the tranche structure of the SBBS, as happened with lower-rated subprime mortgage tranches in CDOs.
Short-term bills
Germany’s resistance to risk-sharing has kept alive the notion of short-term euro bills,Opens a new window a concept floating around since 2011. To make this pooling of debt more acceptable, promoters have steadily lowered the proposed maturity from the original two years to six months.
The idea is to establish a temporary eurobill fund comprising bills from EU members. Countries breaking the fiscal rules would be excluded and no member would be liable for another member’s debts. The bills would be useful for banks, which need a steady supply of sovereign debt to fund operations.
Some economists see this as a step in the right direction, but it would almost inevitably bring pressure for member states to share liability – the mutualization of debt that Germany dreads so much.
In a sense, Hamilton had it easier. The EU has no power of direct taxation, whereas Hamilton had tariffs and eventually a whiskey tax. Worse, Brussels, for all its bureaucracy, is not a federal government.
As long as residents of Germany and other EU countries balk at the notion of paying taxes to benefit Italians and Greeks, the prospect of common eurozone sovereign bonds will remain elusive.