Euro Sovereign Bond-Backed Securities, an anagram for colossal stuffee

The EU has unveiled the awaited plan to create Sovereign Bond-Backed Securities or SBBS in Euro, supposedly “to encourage banks and investors to diversify their holdings of euro zone bonds”.

The plan is “meant to address a weakness in the currency bloc that came to light in the 2010-2012 euro zone debt crisis, when banks’ high exposure to their sovereigns’ own debt exacerbated the problems facing banks and euro zone authorities alike”.

This is quite funny really. Even if this was a problem in the run-up to the 2010-12 crisis, that pattern of distribution of holdings has been replaced now by a concentration of ownership within the European System of Central Banks, composed of the ECB and the Eurozone National Central Banks.

The concentration has been caused by the ECB’s Asset Purchase Programmes (“APP”) and is visible in the TARGET2 imbalances, as we recently researched for The Bruges Group.

The total portfolio is around €3 trillion either held by Eurosystem members under APP, or pledged by one Eurosystem member to another as collateral for TARGET2 overdrafts.

We identified SBBS for Bruges Group both as an attempt to unravel APP and the TARGET2 imbalances, and as a stepping stone towards full sovereign debt mutualization in the Eurozone.

The TARGET2 component of the €3 trillion figure showed, at the end of January 2018, the central bank of Spain borrowing €399.0 and the central bank of Italy borrowing €433.2 billion, all collateralized on sovereign bonds of their own governments.

The problem now is that interest rates are rising.

If we model an original 10-year bond with a 2% coupon that a Eurozone National Central Bank, or “NCB”, bought 2 years ago under APP with 7 years remaining, when the Yield to Maturity (“YTM”) was 1%, then for €100,000 nominal the NCB would have paid €106,728.19.

We assume for convenience that all the purchases and sales are made directly after the annual coupon was received by the then-current owner. The NCB has received two interest coupons of €2,000 each in the meantime: one year after purchase and now two years after purchase.

Were the YTM to be the same now with 5 years remaining, the ex-coupon price would be €104,853.43, but if the YTM had increased by 10 basis points to 1.1%, the bond’s price would fall to €104,355.23.

Thus the bond loses €498.20 in value for every €100,000 of nominal owned, given a 10 basis point per annum rise in YTM. This becomes €4,982,020 for every €1 billion of nominal.

Italian government bonds – or BTPs – have seen their yields rise by 40 basis points in the last week, so whoever is holding them as collateral against loans in TARGET2 of €433.2 billion just saw the value of their collateral reduce by €2,158,211,064, or just over €2.1 billion.

As the total portfolio owned by Eurosystem members is over €3 trillion, the owners now have three choices:

• Sell out now and take the loss;
• Sell out later and take a potentially even bigger loss;
• Hold to maturity.

SBBS creates a fourth option: work with the other organs of the EU financial/political complex to create a new entity – the SBBS issuing entity – and arrange for it to buy the portfolio at the same price the Eurosystem members paid for it, however off-market a price that may be.

The Eurosystem has been the main buyer of bonds as interest rates travelled down. Now they have to sell out, in size, and into a falling market. Step forward the SBBS issuing entity to act as the colossal stuffee. Of course then it will issue further bonds securitized on the underlying bonds, and paying a blended rate to the end-investor.

Even better if the end-investor can be forced under ECB/European Banking Authority rules to SBBS. So it will be the end-investor – commercial banks – who are the intermediate stuffee of this scheme, and they can defease the cost onto the hapless general public through higher loan interest and even lower deposit interest.

The ultimate colossal stuffee of this scheme is thus the hapless Eurozone taxpayer.

That is why SBBC is a stepping stone towards full mutualization of Eurozone sovereign debt.