Are the Germans down for eurobondage?

Germans have a reputation. But financially they’re supposed to be quite boring. The question is, which side will win out when it comes to eurobondage?

Eurobondage is a type of debt slavery. By tying your own sovereign debt to someone more exciting, you strengthen your bond with them, but weaken your bonds – the ones traded on financial markets.

Until recently the debate was simple. Should the eurozone countries issue something called eurobonds? These are bonds denominated in euros and issued by the eurozone nations as a group, not as individuals.

The Brussels-based think tank Bruegel proposed such a scheme in 2010. It’s a typical example of European integration valued more than financial common sense. Only the benefits are mentioned by the people supporting eurobonds because it’s a politically motivated project. Those opposed are only allowed to mention the downsides as they have to oppose political tactics, not engage in a reasoned argument. The result is a stupid debate.

In short, eurobonds mean countries with bad spending habits could suddenly share in Germany’s good credit rating. And the Germans would see their credit rating corrupted.

Leaving aside that Germany’s balance sheet and spending habits are both out of control too, there’s an obvious problem. If profligate countries can borrow more cheaply, they’ll spend even more. The whole point of sovereign debt trouble is to hold countries to account for their overspending. Without consequences, why be reasonable? Imagine if you had to weather your son’s hangover. He’d drink more…

Pro-Europe commentators argue that Europe’s problems come from a lack of integration. If Greece could borrow at German rates, it’d have no problems. If you bashed your head against a wall to recreate your son’s headache, he’d stop drinking.

But we just went through integration and its results. The eurozone nations shared a monetary policy since the creation of the euro. It was an unmitigated disaster. First bubbles in the PIIGS and doldrums for Germany. Now Germany is booming and Greece is still in trouble.

Pushing for more integration is a prime example of the definition of insanity – doing the same thing and expecting a different result.

Anyway, Germany fought off the idea of eurobonds for now. It wants nations to run stable financial positions before they get access to Germany’s credit ratings. Politically motivated projects are fine by Germany, if they make economic sense too.

But the pro-Europe meddlers are undeterred. Now they’ve turned to a less direct route for stealing Germany’s credit rating.

Having learned from the subprime disaster, the latest idea from the European Commission is to use the very same methods that blew up the financial system in 2008. Instead of securitising subprime mortgages, the Europeans want to securitise subprime sovereign debt.

Learning nothing from experience

You might remember the explanation that everyone repeated endlessly in 2008. Securitisation seems so hard to understand. Magical, even. In the end, it’s no different to the show bags you can buy at the fair. These are a way of getting rid of toys and sweets nobody in their right mind would buy in the first place. By putting them in a colourful mystery bag and presenting these in front of kids on a sugar high, you can get rid of stuff nobody wants. These days we’ve ended up with an entire industry making crap toys for show bags.

Let’s review actual securitisation briefly too. An SPV (like a trust) is packed full of mortgages. It then issues tranches of bonds that are rated from AAA to B or below. Investors buy those bonds and collect the interest payments. The aim here is to bundle up a bunch of mortgages and turn them into more predictable investments for people to buy in bite-size chunks.

When there are defaults on the original mortgages, only the investors of the B grade bonds lose out at first. If there are enough defaults, investors of the BB start to lose out too. The more defaults, the higher and higher up the chain the losses are felt.

The basic idea of securitisation isn’t such a bad idea. It allows diversification, investors can select which level of risk they want to accept and many more people have access to mortgages because of the demand for them.

The problem with securitisation is how it changes incentives for the people involved. Bad borrowers suddenly find there’s plenty of people willing to lend to them because they can pass on the risk of the loan to someone else. Banks, mortgage brokers and investment bankers who set up the whole process discover nobody ever bothers to check the original mortgages put into the SPV and they can therefore lie about what they are.

The result is that the method of securitisation becomes blamed for the fraud which corrupted it. This is true in the sense that securitisation is easily corrupted. But done properly it can be great.

Enough history. Back to the Europeans’ new plan to securitise their sovereign debt and what it means for you. The idea is the same as for subprime mortgages.

What is the eurobondage safe word?

The new proposal from the European Commission is to put a bundle of European government bonds into an SPV and then issue bonds for investors, just as with subprime mortgage securitisation. It’s calling them “European Safe Bonds”, which must sound good in French or something.

The thinking is the same. Struggling countries like Greece can’t borrow at reasonable interest rates, just as American subprime borrowers couldn’t. But by creating securities which feature Greek debt in them, there would be an increase in demand for Greek bonds, reducing borrowing costs for the country.

What’s really going on here is that the problems of eurobonds are being sidestepped. A faux fiscal union is created by packaging eurozone sovereign debt together inside financial markets, instead of doing it before accessing financial markets by issuing eurobonds.

It’s a stepping stone to integration. The fact that the idea is stupid suits EU politicians just fine as its failure will trigger the real thing – genuine eurobonds. Setting up policy failure to justify further integration is a staple of EU strategy.

One of the main reasons to create these instruments is to ensure Europe can finance the fallout of the next big financial crisis. Bank rescues and unemployment cheques will be expensive.

This is extraordinarily ironic. The biggest risk to the European financial sector is dodgy European sovereign debt in the first place!

Securitisation also means that governments can default without chaos. If only investors in the lower-rated tranches take a hit if Greece repudiates its debt, then doing that suddenly becomes financially viable. It’s like the jingle mail phenomenon in some US states. People can walk away from their debt and nobody even knows for sure who it affects.

But when Spain and Portugal see Greece defaulting without triggering chaos, they’ll want in on the free lunch. And we’re back to where we started.

My favourite part of the whole story was highlighted by the Financial Times:

Valdis Dombrovskis, vice-president of the European Commission responsible for the euro, said the move would require regulatory changes to make the securities attractive to banks and other investors. One idea would be to grant the new bonds the same “zero-risk weighting” that currently applies to government debt in the EU, which would exempt them from capital requirements. “There would need to be an incentive,” Mr Dombrovskis said. “We see this incentive in the form of preferential regulatory treatment.”

In other words, the eurozone policymakers would have to fudge the rules to make the new securitised investments popular. As soon as you do that, the whole idea is politically corrupted. And the fact that they need to do it tells you just how good this idea really is. Mr Dombrovskis had to emphasise the creation of a “European brand” of debt rather than any actual economic benefits from the plan.

Another strange aspect to all this is that banks are perfectly capable of holding a mixture of European sovereign bonds already. They can create a portfolio that mimics the SPV themselves. So why create one for them?

Banks set to buy the higher rated bonds from the SPV could just buy German sovereign bonds. Banks who want a riskier bet buy Spanish. And so on. There’s no need to securitise sovereign debt if you’re selling the SPV’s bonds to the banks. The same goes for big pension funds and insurance companies.

The only reason to securitise is to make the assets in the SPV easy to invest in for people who ordinarily couldn’t. You and I can hardly buy a mortgage from an investment bank. But we can buy a bond from an SPV that’s really just a bundle of mortgages.

So why securitise sovereign debt and then make the resulting bonds politically favoured? It’s all about the branding and steady progress towards eurobonds.

Are we missing out on the eurobondage fun?

It’s easy for Brits to say “lucky we’re not in the eurozone” or “lucky we’re leaving the EU”. But that’s missing the point. Many people laughed at the Americans’ penchant for subprime loans until all hell broke loose in London just as much as New York.

Britain is very much tied up in this problem, whether we like it or not. Our banks are in danger. Our government’s sovereign debt will be affected by any flows into and out of European sovereign debt. And our financial markets will be used to make the European Safe Bonds a reality.

That’s why, each time I think it through, bitcoin becomes a more and more obvious way to trade Europe’s coming disasters. With enough political will, the eurozone members will be able to stave off disaster by securitising their debt. But this only raises the stakes. The round will last longer but someone is going to lose more chips in the end. If Germany ties itself to Greece, it will end up in trouble too.

The real question is whether Europe is bluffing and I think the answer is an obvious yes. They don’t have any decent cards except for the “European brand”. And that’s worth less every crisis.

But thanks to how closely we’re tied to Europe, and how fragile financial markets are in a crisis, only non-financial bets are safe if you want to punt on a crisis in Europe. Bitcoin and its fellow cryptocurrencies are perfect. One in particular.

Until next time,

Nick Hubble,
Capital & Conflict

Category: The End of Europe

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