A salve for Spain's burning bonds

Now that I have discussed the problems in Spain, what can be done about these? The main question here is that of rising yields – how can these be brought down for Spain (and Italy) in the near term. This article outlines the options available to Europe's regulators and weighs up their effectiveness.

A reactivation of the ECB's SMP

Around this time last year, as Spanish and Italian were spiking, the European Central Bank reactivated its Securities Markets Program and started buying significant quantities of Spanish and Italian bonds in the secondary market. This immediately brought the yields down for two reasons. First it introduced a large new buyer in the market, thereby changing the supply-demand dynamics, and second, it created an expectation that the ECB was on the lookout and would intervene when necessary to create a ceiling for how high bond yields would be allowed to go. However, as it became increasingly clear that the ECB intervention was limited and not open-ended, the impact of the second effect dissipated. The ECB itself was very insistent that the program was limited in time and size. The ECB cut down its purchases to zero and has now not bought any bonds in the secondary market since March. In total, it bought about €220 billion of bonds under the SMP. Hence the impact of its intervention was only temporary. Such ECB intervention, through a reactivation of the SMP remains a likely possibility but there are good reasons to think that it would be even less effective this time round, unless there is change to the way it's done.

Without any explicit change in policy, market actors will rightly assume that the more Spanish and Italian bonds the ECB buys, the larger the haircuts they may face if this debt is eventually restructured as the ECB would once again refuse to take any losses. This rational fear of larger potential losses combined with the evidence that when the ECB says limited intervention it means it implies that the positive impact of any ECB purchases is likely to be less than last time round and will dissipate more quickly. In fact, any ECB intervention can and will bring yields down in the short-term but may actually leave yields higher than before the intervention once the immediate effects dissipate as the residual risks that remaining private bondholders face would actually be higher in the event of a restructuring. On this issue of seniority my stance is more subtle than that of others who simply say that seniority is bad, but suffice to say that in this case it is a real problem. So the ECB could reactivate the SMP but it would only provide temporary relief.

EFSF/ESM purchases of Spanish and Italian bonds

The current terms of the EFSF, the eurozone's crisis management fund and the soon to be launched ESM allow them to purchase eurozone government bonds in the primary or secondary markets. The problem with this option, which could be activated if eurozone governments agreed, is that while this would bring yields down immediately, the limited size of the funds, which simply do not have enough firepower to support Italy or Spain beyond a few months, means that this could at best serve as a stop-gap measure. Unlike the ECB, which could be much more effective, if it chooses to, by making an open-ended intervention and saying it won't claim seniority, there is little that the EFSF and the ESM could do by themselves to make their interventions more effective. In fact, the ESM's interventions may have the same negative impact as the ECB's future interventions unless it also explicitly rules out any claim of seniority.

A fully-fledged bailout wherein Spain was taken off the market and the EFSF/ESM financed it through loans would once again confront the same issue of the funds simply not being large enough to credibly support Spain and Italy on which the markets would focus next.

EFSF/ESM first loss guarantees

The option for the EFSF to be able to provide first loss guarantees against sovereign bonds was discussed in earnest last year and adopted with some fanfare but has never been used. There is some renewed discussion about using this. If this option is used in a credible manner and sold as ‘Germany and other strong countries guaranteeing Spanish and Italian creditors against losses willingly because they believe that such losses will never materialise', it would have some impact on bringing yields down. In particular, the crisis funds need to be credible that if the proverbial shit does hit the fan, Germany and other countries would indeed fulfil their obligations and repay creditors for the amounts of losses insured.

Microfinance, where collective liability can compensate for high individual credit risk may be a useful model to look at. The point about such an option is that it leads to behavioural changes. If Germany and other countries put their taxpayer money on the line as a junior claim in the event of a Spanish default, they won't just sit still but would have a very strong incentive to make sure that Spain does not default.

But such credibility is hard, if not well-nigh impossible to achieve, particularly at the same time that countries such as Finland are insisting on collateral from Greece and Spain for their share of EFSF lending. This is the exact opposite end of the spectrum from the kind of equity-like stake that a first loss guarantee would imply. ESM seniority is also obviously completely incompatible with any credible guarantees.

Another problem with such as guarantee would be that it would not work if it only protects investors against say the first 10 per cent of loss. It would need to go much further – perhaps loss protection up 33 per cent would be needed to make investors feel more comfortable given that the expectations of haircuts, if debt restructuring were indeed necessary, is substantial. The problem of the limited size of funds would once again come to the fore.

Last but not the least is the problem that if such guaranteed bonds were issued, it would create a two-tier market. Investors may flee the market in non-guaranteed bonds towards that in guaranteed bonds. This would depress the market value of the stocks of existing bonds further putting pressure on the Spanish banking sector. It would also mean that there may be a problem of exit from the issuance of guaranteed bonds as the demand for the non-guaranteed bonds may have dried up by then.

In short, such an option, used sensibly, could help in the short-term but comes with several problems and limitations of its own.

Banking licence for the ESM

This sensible option, of providing a banking licence to the ESM thus giving it access to the ECB's line of credit and making it an eligible counterparty for the ECB, has been proposed and rejected outright. But given how bad things look, there is a possibility that this may be put back on the table. Essentially, the ECB, which accepts sovereign bonds (amongst other assets) as collateral to provide funds to private banks, would then be able to provide such funds to the ESM which could essentially deploy these to buy even more sovereign bonds.

This could significantly increase the effective size of the ESM as in essence. The only theoretical limit to how far this can go will depend on the haircuts imposed on the collateral by the ECB.

Much less clear than the technicalities of this solution are the politics. Any decision on the use of the ESM as a bank to tackle the euro crisis will work only if it has the full and continuing support of all 17 member states as well as the ECB. It is exactly this which imposes very serious political obstacles on this option seeing the light of day despite the fact that this is otherwise a neat idea.

Credit risk indemnity for the ECB

Another idea, which we first floated last year, would be for the ESM to indemnify the ECB against any credit losses on its purchases of sovereign bonds. This could then free up the ECB's hands to enact a much larger SMP. Economically, this is similar to the ESM bank model as the credit risk is taken on by the ESM and the funding comes from the ECB. However, unlike the ESM bank idea, which has explicitly been ruled out by key political actors not least Mario Draghi himself, this idea has not been vetoed, yet. One could see how this may politically be more attractive than some of the other ideas that have been discussed but yet be economically workable.

The ECB is very clear that they will not ask for such an indemnity but what if the ESM were to offer one?

The discussion in this article has focussed on what can be done in the near-term. The fundamental problems we face are two-fold. First, whatever is economically workable does not seem politically feasible and second, that without a broader more comprehensive solution to the euro crisis any steps to address spiking yield would only have a temporary impact. For example, if the possibility of a break-up of the euro is not credibly taken off the table, the logic of the dumbbell trap, in which the eurozone is presently struck, will continue to dominate.

Sony Kapoor is a former investment banker, derivatives trader, and adviser to governments and international organisations.

This piece, the second in a two-part series, is the edited extract of an article first published by re-define.org. Reproduced with permission. Read the previous article here.