Eurobonds Will Just Deepen The Euro Debt Crisis

Hyperinflation, Europe

Photo: Magyar Nemzeti Múzeum Történeti Fényképtára, Budapest

There has been written much about the Eurobonds and their usage as ultima ratio to secure funding for some members of the EMU.In the personal opinion of the author, as well as the opinion of the German Press and Chancellor Angela Merkel, they are not necessary.

The author would like to point out here, that a cheaper financing is not the final solution for the debt crisis, but rather a firther step in it.

Further, the author puts forward an alternative proposal for the funding of weak EMU members.

Much focus has been put on the revenues of governments in the past and present.

Most people seem to ignore that they also do have a huge amount of assets, may it be property, state owned companies, rights or even gold.

These could be used in funding the respective countries, without the need of selling them.

The main focus of public discussion in Germany is the liability, which is associated with the German participation in Eurobonds. On the other hand Eurobonds could hardly be placed without Germany taking the largest share of the obligations.

This would increase the funding costs for Germany somewhere in the range of 20 to 25 billion Euros, according to calculations of the Bundesfinanzministerium. To preserve usefulness  for German economy and still remain politically feasible the liability and the impact of interest rate would have to be eliminated.

Here the author recommends the use of a very old and not so “fancy” debt instrument – the German Pfandbrief. As one of the first covered bonds established by Frederick the Great of Prussia in 1769 it is, to the best knowledge of the author, the only instrument, that has never defaulted.

Taking into account the latest swings of global indices, such an instrument might be welcomed by many investors. The secret of the Pfandbrief and its default security lies within its construction:

  • The Pfandbrief is regulated in an own strict law (Pfandbriefgesetz), that protects the investor with several information rights. The law also provides a very high and strict standardization, which differentiates it from all other covered bonds. This can be seen from the spreads, that seem to be unmovable even during the roughest times of the financial crisis.
  • Every Pfandbrief is by law 200% over collateralized, with the first 100% being the issuing bank and the second 100% the collateralized loans.
  • As opposed to other securitizations, the liabilities a Pfandbrief refunds, remain on the balance sheet of the bank and the bank takes eventual losses.
  • The collateral that can be used is tightly regulated, as well as very conservatively valued. Only a small fraction of prime assets are eligible as collateral and even those assets are valued, using a big discount. In the case of property, it is only allowed to be used up to 60% of the market value as collateral. Therefore the investor has a 40% cushion on losses on the collateral.

But how could all those characteristics be integrated into the Euro-Pfandbrief, that can be used to fund the Euro-Countries in need? How could such an instrument look like?

The idea is pretty simple. A central institution would issue the Euro-Pfandbrief (henceforth institute). The institute would take over the role of the issuing institution (Pfandbriefbank) and therefore needs to be sufficiently funded, which is for example already the case for the EFSF with a AAA Rating.

The institute also acts as a custodian of the posted collaterals. Countries that are currently paying high interest rates and are in poor financial shape arrange their debt according to a Pfandbrief. This implies getting a direct, cheap and collaterized loan from the institution, where the loan is refunded with a Pfandbrief.

It is here of utmost importance that the countries stick to the very strict rules of the Pfandbrief law and those are not watered down (weakend) in any step of the process. To debt covenance (issuing conditions) have to be taken from the law, which would guarantee the very low interest rates of around 3,5% for 15 years[1] and also grant access to the capital markets.

The countries would be required to post the collateral like prime real estate or other highly desired assets of theirs for the loan. The collateral would need to adhere to high standards, as well as include a considerable discount in the valuation to protect the investors (e.g. the aforementioned 40% discount for real estate).

The collateral as well as the capital of the institution would again act as the 200% security cushion for the investors. It is also part of this proposal that the individual countries do not pool their assets or jointly issue the covered bonds.

It is rather the idea that with such a strict regulation almost every country could get access to the capital markets (on the repeated basis). The German Steuerzahler (Tax payer) would be relieved, since the only financial risk to Germany would be the capital invested in the institution.

Please note the many advantages of using such an instrument. In case of the insolvency of the central institution the whole collateral would be used to satisfy the claims of the Pfandbrief-investors, before all other creditors. Also the Euro-Pfandbrief would enable every participating country to post their prime assets only as collateral and not be needed to be sold at fire sale prices.

This would also most likely be welcomed by the public in any country considering the Euro-Pfandbrief. One has also to take into account that a standardization of such bonds would come with another benefit. It might create a market, that could rival the US Treasuries and would therefore be one of the most liquid in the world. Therefore liquidity and security for investors could be offered via such an instrument.

Summing my idea up, the EMU would need to create a central institution that would give the credit to distressed countries of the Eurozone. They would be collaterized and adhere to the strict standards of a Pfandbrief. This in turn would enable the central institution to refinance itself again on the capital markets using as the main instrument the Pfandbrief, which would be very cheap.

No country would need to pay the debt of the other countries, besides the capital investments into the central institution. Given the track record of the Pfandbrief it would most likely a highly desired instrument by many investors. The downside is that there is still a lot of persuasion to be done to the political community to accomplish the proposal within the EMU.

[1] As of writing this article on the 31.08.2011 according to http://www.deutsche-hypo.de/ ranging from 1,5 % for one year to 3,53% in 15 years.

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