How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies) Primary Credit Analyst: Moritz Kraemer, Frankfurt (49) 69-33-999-249; [email protected] Table Of Contents European Safe Bonds 101 Possible Rating Approaches For ESBies ESBie Ratings Are Still Far Off Related Research External Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 25, 2017 1 1837013 | 300031015 How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies) Investors and policymakers have been discussing the concept of European safe bonds (or ESBies) for several years. But market interest has reached a new dimension since the European Systemic Risk Board (ESRB) published its working paper on ESBies--also referred to as sovereign bond-backed securities--a few months ago. In that regard, S&P Global Ratings has received several questions from various stakeholders on how it would rate such an instrument. Our rating approach will of course depend on the details of the bond's underlying structure, which are still unknown. Overview • European safe bonds (ESBies) have been proposed as a tool to increase the supply of 'AAA' rated euro-denominated assets and reduce systemic risks from banks' large holdings of bonds issued by their respective sovereign governments. • But we believe that ESBies will probably reduce the supply of 'AAA' rated assets instead, since some 'AAA' rated sovereign bonds are likely to be repackaged into lower-rated ESBies. • Given the lack of diversification of the sovereign bond portfolio underlying ESBies, and the high correlation of eurozone sovereign default risk, we would likely rate ESBies in the lower half of the investment-grade category. European Safe Bonds 101 The basic idea behind ESBies is that a special-purpose entity would issue two (or more) tranches of securities backed by a pool of government bonds of the 19 eurozone members. There would be no joint liability of eurozone member governments or any other explicit form of combined sovereign risk-taking. This is an important difference from the often discussed idea of a common government Eurobond. According to the ESRB's working paper--"ESBies: Safety in the tranches," European Systemic Risk Board Working Paper 21, September 2016--the senior tranche (the ESBies) is assumed to represent 70% of the total issuance and be "at least as safe as German bunds." The paper also states that ESBies "promise to approximately double" the supply of 'AAA' rated eurodenominated financial instruments. On the other hand, the junior tranche (European junior bonds, or EJBies) that makes up the other 30% would have "expected loss rates similar to those of vulnerable euro area sovereign bonds." This means holders of ESBies would be protected by the junior tranche, which would take the first losses. Investors in ESBies would therefore experience a loss only if at least 30% of the underlying government bond portfolio were to default. Proponents of ESBies expect that an important benefit would be the breaking of the so-called doom loop between banks and sovereigns, thereby reducing the eurozone financial system's overall vulnerability to shocks. The doom loop expresses the concern that a sovereign's creditworthiness can come under pressure if it needs to bail out failing banks to secure financial stability. In turn, banks' finances could suffer if the sovereign government in their country of domicile were to default on its bonds, since some banking systems in the eurozone hold a substantial amount of WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 25, 2017 2 1837013 | 300031015 How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies) home-sovereign bonds. These two effects can reinforce each other, creating a vicious circle; so a circuit breaker is called for. The new EU bank resolution regime is supposed to mitigate the first half of the doom loop (weak banks hurting government finances). But the second part (weak sovereigns hurting banks' finances) remains largely unaddressed. Attempts to reduce that risk through the introduction of risk weights for government bonds or single exposure caps have failed to find consensual support from the eurozone's policymakers. ESBies are designed to diminish sovereign risk for banks by enticing them to hold a more diverse portfolio of eurozone sovereign bonds. Before ESBies can become reality, however, there are several hurdles to overcome, not the least of which is the design. A few of the questions on that point are: Who should the issuing entity be, how to ensure consistency among different series of ESBies, what liquidity risks would the underlying sovereign bonds pose, and how to align the coupons and bullet repayment of the underlying bonds. There is also the matter of regulatory treatment of ESBies vis-à-vis standard government bonds. Whether there would be sufficient investors for both the senior and junior tranches, to make the market size for ESBies meaningful, is also a subject of debate among market participants and policymakers. A more fundamental question is whether banks would actually want to replace their holdings of home-sovereign bonds with ESBies. After all, they already have the option of investing in a more diversified portfolio, but tend to favor bonds issued by the host country. Given the lack of precedence, these questions remain unanswered. One additional topic that keeps coming up is how ESBies would likely be rated. Possible Rating Approaches For ESBies In principle, ESBies are the same as a senior tranche of a collateralized debt obligation (CDO), in which a large number of assets (typically corporate bonds and/or loans) are sliced into different tranches. The most junior tranche of a CDO would be hit by the first loss and therefore be the riskiest. The senior-most tranche would be at risk only if all more junior tranches have been wiped out by defaults and credit losses. The tranches are sold as separate tradable securities, with the senior tranche enjoying a high credit rating, often 'AAA'. But there are two important differences: • For CDOs, the underlying pool consists of discrete assets, each not accounting for more than a tiny fraction of the total. The pool backing ESBies, on the other hand, would comprise no more than 19 distinct assets (corresponding with the 19 eurozone sovereigns). Some individual government bonds (e.g. Italian government bonds) could make up a substantial portion of the total. • Arrangers of CDO attempt to reduce the risk by bundling independent assets that have little or no intercorrelation. That way, underperformance in one part of the pool would not infect other parts of the pool, or could even be offset by overperformance elsewhere. For ESBies, the situation is different: The eurozone crisis showed that there is a significant correlation among European sovereign bonds. The crisis affected several EU countries simultaneously, resulting in high positive correlations between government bond yields and default risk across sovereigns. For example, reflecting eurozone-wide systemic risk rather than idiosyncratic risks, we lowered our ratings on nine eurozone sovereigns simultaneously on Jan. 13, 2012, at the height of the crisis (see "Standard & Poor's Takes WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 25, 2017 3 1837013 | 300031015 How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies) Various Rating Actions On 16 Eurozone Sovereign Governments," published on RatingsDirect). As a consequence of these two differences, the scope for using diversification to reduce risk is significantly narrower for ESBies than for CDOs. In fact, the high positive correlation with sovereign bonds and likely large size of the underlying sovereign bonds suggest that a weak-link approach would be more appropriate for rating ESBies than a CDO approach. In fact, standard quantitative tools to analyze CDOs cannot meaningfully process calculations on the undiversified ESBie asset pool. Under our weak-link approach, we would rank the underlying sovereign bond assets from the lowest rated (e.g. 'B-' for Greece) to the highest (e.g. 'AAA' for Germany, Netherlands, and Luxembourg). If the junior tranche is 30% of the issuance, our rating on the senior tranche (ESBies) would be equivalent to the next highest sovereign bond rating directly above the 30% mark. Assuming that the underlying pool's structure is in proportion to the size of the respective sovereign bond markets, then the rating on the senior tranche would be equivalent to 'BBB-' (see chart). This is because Greece (rated 'B-') accounts for 0.2% of the eurozone's sovereign bond market, Cyprus ('BB-') 0.1%, Portugal ('BB-') 2.5%, and Italy ('BBB-') 27.6%; the sum of those shares is just above 30%. We expect that sovereigns will default in the order of the ratings, with lowest-rated Greece defaulting first. ESBies would only be in default after Greece, Cyprus and Portugal, and Italy have defaulted--in that order. The rating on the ESBies represents the probability of that event and is therefore equivalent to the 'BBB-' sovereign rating on Italy. If the junior tranche were enlarged to 40%, the indicative rating on the ESBies would be higher, at 'BBB+', equivalent to the next weakest sovereign rating, that on Spain, which represents 13.2% of the eurozone sovereign bond market. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 25, 2017 4 1837013 | 300031015 How S&P Global Ratings Would Assess European "Safe" Bonds (ESBies) These calculations are a rough approximation. The correlation of default risk among eurozone sovereign issuers may be lower in the future. The key factor determining the structure of the assets may not be the amount of outstanding sovereign debt but GDP, which would reduce the weight of lower-rated and highly indebted sovereigns. What's more, post-default recoveries could have a positive effect on the assessment of ESBies (our sovereign issuer credit ratings are opinions on probability of default only, not on recovery).