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ABS – can the villain become the hero?

15 June 2017 by Luca Beldi

Since the sovereign debt crisis, European policymakers have been looking for a way to create a form of public debt which is disassociated from the borrowing requirement of each individual member state.

As the bulk of sovereign debt is held by domestic banks, with banks in the ‘PIIGS’ area holding as much as 90% of their local public debt, a shock in the value of government bond in a single country could quickly become a systemic problem. Accordingly, policymakers have been looking for a new instrument aimed at significantly mitigating this risk.

The concept has raised a number of questions as to how such “supranational” obligations might technically work, as well as how they might impact the cost of financing for each member state.

On the last day of May, the European Commission released a “reflection paper on the deepening of the economic and monetary union” outlining a potential new method of creating a European debt instrument and, perhaps surprisingly, it’s essentially an asset backed security!

Their proposal outlines the creation of a new product called ‘Sovereign Bond-Backed Securities’ (SBBS), which constitute senior and junior claims on a diversified portfolio of euro area sovereign bonds.  Or in other words – two-tranche asset backed securities collateralised by pools of sovereign debt from member states.

The details of this instrument are highlighted in a previous theoretical paper, which included input from the ECB and the European Commission, that highlights how a senior tranche sized at 70% of the total pool would be “slightly safer than the untranched German bund” and could therefore be seen as alternative “risk-free” bonds, while the junior piece could be used by traditional asset managers and hedged funds as an approx. 3x leveraged investment on European govies.

This solution would require limited change in the current regulatory framework and would not require states to change their public debt issuance practices.

Since the financial crisis the ABS market has suffered significant levels of criticism, and in some cases vilification, from the press, politicians and policymakers amongst others, despite generally excellent underlying asset performance. However, in recent years there seems to have been an inversion of the trend. The ECB led with its ABS Purchase Programme and the development of a harmonised regulatory framework for securitisation under the Capital Markets Union initiative, which has been expressly designed to revitalise securitisation as a funding tool for the real economy. Now the European Commission is following suit recognising the value of securitisation as a potential central sovereign funding tool.

So somewhat surprisingly, it could be that the product that was once considered to be the cause of the problem, can actually become part of the solution.

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