Unfreezing the Euro Area Government Bond Market
A core source of the current problem is that the euro area government bond market has transformed from a "rates market" focused on yield curve shape and direction into a "credit market" focused on default risk. As a result, many European financial institutions find themselves holders of hundreds of billions of euros worth of risk assets (e.g. Greek government bonds) that they had held as riskless assets. Remarking these securities to reflect market values and the recategorising them as risky assets have profound risk management, accounting, and capital implications that will substantially affect the ability of institutions to continue to hold these bonds. To address these challenges, we suggest a mechanism to further stabilise the market: A Euro Debt Assured Purchase agreement program ("EDAP"). An EDAP would be a standardised agreement applicable to a specific euro area sovereign issuer. In the event of a default by that issuer, the holder of an EDAP would have the right to sell their holdings at par to the ECB. The term of an EDAP would be five years and only bonds which currently have remaining maturities shorter than five years would be eligible for pairing with the contracts for delivery to the ECB. EDAPs would be issued through an auction process, and should be priced somewhere between currently exaggerated sovereign spreads and normalised market spreads. By way of illustration, a €75 to €100 billion EDAP program for Greece could be sold via a series of Dutch Auctions requiring a minimum payment, set by ECB, for each auction. For example, the buyer pays 5% of par upfront and 2% per year for five years. This solution has several important merits as a complement to outright purchases of government securities by the ECB in facilitating a return to normalised markets. First, EDAPs can be channelled to the most unstable part of the current euro area government bondholder base. Financial institutions might find themselves constrained in selling positions into the market for a variety of economic, regulatory and accounting reasons. EDAPs constitute an effective means of immediately reducing credit risk, while fully protecting capital. The applicable cost would be incurred over a manageable five-year period. For holders under pressure to sell regardless of constraint, EDAPs become the mechanism by which the grinding market pressure that arises from forced liquidation is materially reduced. Second, EDAPs allow current holders to retain their existing bonds or redistribute them in an orderly fashion. In auctioning EDAPs, the ECB retains the same credit risk as outright purchases, but without the dilemma (and consequent material overhang to markets) of having to redistribute a substantial volume of bonds at a future point. Third, EDAPs should help stabilise the euro area banking system. EDAPs paired with underlying government bonds would be valued near par, greatly reducing mark-to-market exposure. The availability of EDAPs and, thereby, consistent financing for paired bonds, should attract new cash buyers for the bonds covered by the EDAPs. The market would thus function more normally without the ECB intervening as a purchaser of bonds. Finally, EDAPs are intended to facilitate secondary market stability, in contrast to third-party guarantees of new government debt issuance. As such EDAPs are not bailouts. When EDAPs are no longer necessary, the ECB can simply repurchase them from the market. EDAPs are not credit default swaps (CDS). The ECB would be the only issuer of EDAPs, and the exercise of the EDAPs would require delivery of the underlying government bonds plus all remaining payments still owed. There is no cash settlement option. EDAPs are not subject to margin calls if the value of the underlying security declines, because of the creditworthiness of the only issuer – the ECB – is unquestioned. The agreements would be transferable, but in a regulated fashion, with the National Central Banks of the Eurosystem at all times knowing who owns EDAPs. European authorities already have made tremendous progress in stabilising markets. Time is now of the essence and the authorities should continue to be bold and innovative in working to accelerate the impact of the available lines of support. EDAPs provide the ECB and policymakers a powerful, transparent and cost-effective tool for use alongside existing mechanisms as they work to restore the proper functioning of the secondary markets without the need for sterilization. Nazareth Festekjian is a Managing Director at Citigroup Global Markets. |
The European Union and the ECB have taken impressive and unprecedented actions to stabilise financial markets over recent weeks. As authorities consider complementary steps, we propose the use of a portion of the resources pledged to the ECB in a highly-targeted fashion that would minimise moral hazard and free-riding, while eliminating the need for monetary sterilisation.