Handelsblatt Exclusive The Secret Debt Plan

The European Commission and central bankers are working on a proposal for a new financing instrument for euro-zone countries that some view as a kind of euro bond - something Germany has long opposed.
Jean-Claude Juncke has the support of Mario Draghi to set up European Safe Bonds, a type of euro bond.

The European Commission is drafting a proposal to bundle some debt of the euro-zone states into a new financing instrument called “European Safe Bonds,” according to information obtained by Handelsblatt.

The goal of the bonds would be to reduce the risk of member states going bankrupt or contagion spreading through banks. The commission aims to publish a white paper on the subject in March.

But opposition is already building in Germany. The finance ministry’s advisory council warned Finance Minister Wolfgang Schäuble in a letter that the proposal amounts to implementing “eurobonds through the backdoor.”

Potential investors - financial giants like BlackRock, Morgan Stanley and Goldman Sachs - are also skeptical.

The German government has already signaled to Brussels that it opposes the proposal, according to E.U. diplomats.

But the European Commission apparently has the support of the central bankers who will publish a report two days before the commission’s white paper.

According to Handelsblatt information, the experts support the idea of safe bonds, much to the frustration of some E.U. member states, who believe the central bank has no business helping the commission create new instruments for state financing.

The strongest criticism came from the debt agencies of euro-zone countries, which said the bonds would not be a reliable refinancing instrument

The new financing instrument is intended stabilize the euro zone during times of financial crisis. Put simply, some government bonds from euro-zone countries would be bundled together to form new securities and passed on to investors.

While this sounds extremely technical, the German central bank, and the German finance ministry fear it could herald plans for debt liability to be communitized at European level.

The German government has long made it clear it is opposed to any sort of euro bonds that would create this joint liability.

When the euro crisis was heightening in the summer of 2012, Angela Merkel said there would be no eurobonds "as long as I live."

But the European Commission, and the European Central Bank, led by president Mario Draghi, has pressed ahead with the proposals. A working group plans to publish a report on the new bonds by March 23, two days before the commission will present its white paper.

The bonds are not a new idea. They were first proposed by financial economist Markus Brunnermeier in 2011. Together with a group of economists known as "Euro-nomics," Mr. Brunnermeier wanted to develop an alternative to euro bonds that would not involve joint liability. This would be achieved by means of a trick: euro-zone countries would continue to issue their own debt securities, but they would be bundled in a portfolio that would be used to create new bonds, or European Safe Bonds. To produce these safe securities, portfolios of government bonds would be divided into tranches, of which 70 percent would be made up of low-risk bonds and 30 percent of high-risk bonds. The incentive for buyers was that banks would not have to keep equity available for the new securities, as they currently do for government bonds.

The idea did not take off for five years, until the advisory council to the European Systemic Risk Board or ESRB, whose job is to monitor financial stability in the euro zone, brought it up again last year. ECB president Mario Draghi, who is also the chair of the ESRB, instructed Philip Lane, head of the Irish central bank, to "investigate the possible introduction of government bond securitizations" in September.

There have been complaints that the ESRB is overstepping its mandate in doing this, but the ESRB believes the project falls within its mandate as the bonds could reduce risks to financial stability. It also points out that no country has objected to the creation or composition of the working group. Well over 100 experts are now working on the idea.

The plans were presented to over 100 managers of hedge funds, pension funds and major banks at a conference at the Banque de France, France's central bank, on December 9. Although no banks or investment funds have commented on this, their reactions can be pieced together from minutes that have been seen by Handelsblatt and accounts by some of the participants.

One participant said: "The day can be summed up in one sentence: It just won’t work." Major U.S. banks are said to have complained that creating such bonds would be too expensive as the government bonds would have to be stored temporarily, and that it would be difficult to put together packages of similar securities.

It is also uncertain whether there will be sufficient providers or sufficient buyers for the bonds. Even the safe bonds would make debt more expensive for countries like Germany, if the securities did not receive top ratings. U.S. asset manager BlackRock pointed out that there was no shortage of secure bonds in Europe. The rating agency Standard & Poor's declared that it may be unable to give the bonds a top rating.

However, the strongest criticism came from the debt agencies of euro-zone countries, which said the bonds would not be a reliable refinancing instrument. If no one bought the high-risk bonds in a crisis, they said, the entire euro zone may be unable to finance itself without public-sector intervention.

That's precisely what the German finance ministry and Bundesbank are concerned about. In a letter to finance minister Wolfgang Schäuble dated January 20, the academic advisory council to the finance ministry warned against "euro bonds through the back door" and expressed concern that the new instrument could be "particularly susceptible to political influence."

The ESRB is aware of these fears, but is convinced it will be able to allay them and is continuing to promote the idea to investors. It wants to introduce the new securities gradually, to let markets get used to them. It said the bonds would significantly reduce the risk of default for banks if a euro-zone country gets into difficulties and stabilize the financing of euro-zone states, which will be particularly important when the ECB ends its bond purchases.

Financial managers are surprised at the ECB's tenacity in pursuing the idea. Some have speculated it could make it easier for the central bank to sell government bonds, and that the European Union supports the plans as it needs proposals for its white paper. "The bonds are a win-win situation for the European Union and ECB," one financial manager said.

Brussels has become slightly more realistic following the resistance; sources are reported to have said that private banks would issue the new securities only if the state protected them against default risks. Alternatively, the European rescue fund or European Investment Bank could market the securities. Then the bonds would effectively have a state guarantee - and would be almost indistinguishable from euro bonds.

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Ruth Berschens heads Handelsblatt's Brussels office, leading coverage of European policy. Martin Greive is a correspondent for Handelsblatt based in Berlin. To contact the authors: [email protected] and [email protected].