We have long been concerned [12] at the implicit and explicit subordination of both financial and sovereign bondholders in Europe by the actions of their overlords political elite in pursuit of short-term liquidity fixes to insolvency issues. As talk of the ESM coming to life in the short-term and a 'Redemption Pact' in the intermediate term - which as Goldman describes involves mutualizing a portion of each country's debt (resulting in a partial upgrade of the existing pool of Eurozone sovereign bonds) in a European Redemption Fund (ERF) and, in the process, extending debt maturities (kicking that can) onto the public sector's balance sheet. As with all these mutualization schemes, the ERF ineluctably raises the twin problems of 'moral hazard' and 'subordination', which need to be mitigated. Goldman discusses these two sides of the same coin as it notes subordination is explicit when the ESM intervenes (and also with the ECB's SMP) but a little less obvious in the ERF (though still as painful) which is, we note, perhaps more appealing to keep the masses unaware.
Goldman Sachs: Trading Off Moral Hazard against Subordination
As all mutualisation schemes, the ERF ineluctably raises the twin problems of ‘moral hazard’ and ‘subordination’, which need to be mitigated. We consider them in turn.
‘Moral Hazard’: A prominent concern for a fiscally strong countries participating in the ERF is the potential for a relaxation of the budgetary efforts of fiscally weak countries once their debt has been mutualised. This risk is amplified by the fact that, according to the blueprint, the ERF would take over the riskiest part of national debt, i.e., the portion above 60% of GDP.
The Redemption Pact would (only) work under a reinforced conditionality, where countries subjugate their fiscal authority to stringent external control, in our view. The ‘fiscal compact’ and ‘debt brake’ rules not only need to be ratified by all participating countries, but may need to be supplemented by enhanced delegation of fiscal authority (for example, last year Germany's CDU had floated the idea of a ‘Sparkommissar’, an EU commissioner for public finances). Moreover, the Redemption Plan would require sovereigns to pledge assets as collateral (gold, fiscal revenues, government stakes in public companies) to the ERF in proportion to the debt the fund takes over. These assets could be seized (even temporarily) in the event of fiscal profligacy. This seems to be more credible than the penalties currently envisaged by the fiscal compact.
In evaluating the proposal, it is important to consider the ‘moral hazard’ risk embedded in alternatives to the ERF. Open market interventions by the ECB, either through the Securities Markets Program or the LTROs, expose the balance sheet of the central bank to credit risk. Potential losses are mutualised among the ECB’s shareholders on a joint-and-several basis. Further, such ‘risk sharing’ comes without a ‘time consistent’ control over public finances of debtor countries, and no collateral. Purchases by an (ECB-levered) ESM may have conditionality attached to them, but involve explicit subordination of existing bondholders, as the fund enjoys preferred creditor status. The recent experience of Spain illustrates how sensitive markets are to shifts in seniority.
'Subordination’: EMU countries have already agreed to structural budgetary restraint, and reducing public debt steadily (the 1/20th ‘rule’). Some, like Italy, are also contemplating selling public assets to reduce outstanding liabilities. Given this backdrop, fiscally weaker countries may acquiesce to tighter constraints on their sovereignty in fiscal matters and agree to pledge collateral. Their concern, however, will be around the issue of subordination of the portion of sovereign debt that will remain national.
Access to stable funding and reduction in borrowing costs on ERF debt should result in an increase in a country’s ability to service the first 60% of debt. But for this result to hold, it is critical that the ERF is explicitly pari passu with existing bondholders, and that collateralization is appropriately calibrated (in our calculations, we use 15-20% of debt). For this reason, ERF bonds need to be jointly and severally guaranteed by all participants. If the ERF issuance is only severally guaranteed, as some commentators have advocated, the fiscally strong countries, like Germany, would be transferring less of their creditworthiness to the Fund. This would entail that larger collateral pools would need to be transferred to the ERF in order to make its bonds palatable. And the greater the collateral, the bigger the subordination of national bonds.
Subordination is explicit when the ESM intervenes, and the issue has also been associated with ECB purchases. This is important to bear in mind when passing judgement on these different solutions to the crisis through the intervention of the public sector.