Synthetic Bonds Are the Answer to Euro-Area Crisis: Harald Uhlig
The euro area is burning and policy makers seem increasingly powerless to douse the flames. Meanwhile, we can only stand by and watch this nerve-wracking spectacle.
Yet the situation may not be utterly hopeless. In the last month or so, researchers have floated proposals for the creation of synthetic euro bonds that may offer a way out. The idea rests on three principles: No cross-subsidization between countries; safety; and the replacement of risky sovereign debt by synthetic bonds in European Central Bank repurchases.
I know what you are thinking: Are these people out of their minds? Collateralized debt obligations? Synthetic securities? That is what got us into this mess in the first place.
Let’s take a closer look. The proposals all start with some version of an open-ended mutual fund that would hold euro-area bonds. Ideally, the fund would hold these assets in proportion to the gross domestic product of each member country. It would then issue certificates that would be fully backed by these bonds. If there is a partial or full default on one of the securities (Greek 10-year bonds, say), then the mutual-fund certificates would lose some value.
In the case of a small country or a partial default, the losses would be small. So, the certificates would be reasonably safe.
The most important aspect, however, is that there would no mutual bailout guarantees, no cross-subsidization between countries and no need for high-level political brinkmanship. This is the core of the proposal I put forth with my colleagues Thorsten Beck and Wolf Wagner, of Tilburg University in the Netherlands.
We recognize that many people will say that reasonably safe isn’t safe enough when it comes to synthetic securities. We believe they could be made safer. Markus Brunnermeier and his fellow members of the Euro-nomics group propose to divide the mutual-fund certificates into tranches. The junior tranche would be hit first in case of a default. The senior tranche would be most protected and could be called “European safe bonds” or “ESBies.” Both tranches would be traded on markets.
This would slice a slightly risky investment into several parts, one of which is safe. It would be an important feature if the ECB can’t be persuaded to use the raw mutual-fund certificates directly for repurchasing transactions, or if the original certificates are still considered too risky on bank balance sheets.
The biggest disadvantage of this idea is that it is too reminiscent of the infamous alchemy of 2008. I think it can work if properly implemented.
Another proposal by two Italian economists, Angelo Baglioni and Umberto Cherubini would create the original mutual fund, but it would only buy senior debt from governments, which would be required to post cash collateral. That is less appealing because it would require too much political maneuvering, would too easily allow cross-subsidization, and would entail restructuring of current government debt to create securities of appropriate seniority.
But the main point is this: It would be feasible to fine- tune any proposal to ease particular concerns of participants regarding seniority and safety, as long as the three principles I outlined above are obeyed.
The last of the three principles may be the most critical: These certificates must replace risky sovereign debt in ECB repurchasing transactions. One objection to this is that there is no particular reason now, for, say, a Greek bank to hold Greek debt or for a Spanish bank to hold Spanish debt, when they could all hold much safer German bonds.
‘Hold to Maturity’
The banks that can still afford to mark their sovereign debt to market, rather than “hold to maturity” and pretend all is well, can do this now. They can ensure their safety by selling the debt of Portugal, Ireland, Italy, Greece and Spain, and buying German bonds.
The trouble with that scenario is that if all banks were to act this way, the prices of those bonds might plummet. That would mean far deeper trouble for Portugal, Ireland, Italy, Greece and Spain the next time they try to issue new debt. It would cause problems for the banks, too, as they would get even less than what they currently think the bonds are worth.
The ECB has danced around this issue by repurchasing risky sovereign debt, buying it outright in the open market, supporting these prices through intervention, and trying to unwind again. The ECB is ultimately backed by the euro area’s taxpayers, who either get more inflation or a depreciation of their currency, if things turn south.
In addition, the central bank’s actions have had the unintended effect of encouraging private banks to hold the risky assets, rather than discouraging them from doing so. This makes sense: These bonds get higher returns, are still usable as collateral with the ECB, and are implicitly guaranteed by government bailouts if things go wrong. The real loser is the taxpayer.
The mutual-fund construction removes much of this moral hazard. It can buy a sizeable fraction of the risky debt, taking it off the books of the ECB and the commercial banks. Yes, it may still need to buy German, Dutch and Finnish bonds on the market, but the banks, in turn, would buy these certificates. And, importantly, the ECB uses the mutual-fund certificates or their ESB-safe versions for its repo- and open-market transactions, while gradually phasing out its support of individual risky sovereign debt.
Who can create these certificates? A savvy market participant could probably pull this off in a few days. But it would be better to have a public institution do it instead. Competition among several such funds may even be better, with the ECB deciding which ones to accept and which ones to phase out. In any case, this can be done quickly, if decision makers in government and the financial-market institutions can be persuaded to act.
This isn’t a glamorous, magic solution. Nor is it a sexy proposal for politicians to sell in speeches. This is a simple step forward that wouldn’t cost much, but is easy and effective. Most of all, it is what the euro area needs right now.
(Harald Uhlig is chairman of the economics department at the University of Chicago and a contributor to Business Class. The opinions expressed are his own.)
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