Accountability Bond Accounting

by
Robert Waldmann
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Recently I learned about a proposal for Euro denominated “accountability bonds”. They are basically a clever way to enforce the stability and growth pact. I don’t like the pact, so I don’t support the proposal which I made by Clemens Fuerst here . The idea is that borrowing beyond the level allowed by the stability and growth pact could be financed only by special junior bonds. Owners of those bonds would lose everything before owners of senior bonds lose or taxpayers who finance the ESM risk anything.

The key part (which I don’t support) is that currently outstanding bonds are senior to these new bonds. This means that the reform will cause a windfall gain to current bond owners. The value of their bonds will not be diluted by the junior bonds. The risk that it would be diluted by regular bonds issued above the stability and growth pact levels would vanish. Importantly, this windfall would not be openly paid by the Treasury issuing the junior bonds – on its face, the reform regulates only the interaction of those Treasuries with new investors. The windfall would be paid by other investors who value the old bonds more highly. The old bonds will be more valuable in case of default, because they will be more senior than the average outstanding bond (the average including the junior bonds). Since investors in junior bonds won’t pay this cost in (at least subjective) expected value, the issuing Treasury will.

If no junior bonds are issued, old bonds are average bonds so there is no windfall and no cost. Byt the reform appears to only regulate the interaction between issuing treasuries and investors in new bonds. It is a penalty to be levied by investors thinking of their own interests, so it is a penalty which will actually be levied.

I don’t like the windfall (which Fuerst might consider the whole point of the reform). It implies giving people who are on average wealthy something for nothing. It isn’t hard to come up with a proposal for junior and senior bonds, related to the stability and growth pact, which does not create a windfall. The problem (or whole purpose) is that old bonds are senior to the average bond. The solution is to require that, in case of default, recovery ratios for old bonds are equal to average recovery ratios.

My proposal is that as of the start date T, there is a limit on the issuance of new senior bonds. Beyond that limit, new bonds must be new junior bonds. In case of default, first payments (coupons plus face values of maturing bonds) are divided into the proportions due to newer than T and older than T bonds – so payments to old bonds are
(total payments)(amount owed on old bonds)/(total amount owed).

The remaining payments must first go to new senior bonds and any money left goes to new junior bonds.

Discussion of the effects of such a plan after the jump.

In the very silly simplest financial models, the reform would have no effect on the amount the Treasury could raise. Investors all buy equal proportions of all risky assets, so each would reconstruct average new bonds with a portfolio of new senior bonds and new junior bonds. According to these models pooling and tranching is never profitable. These models are silly. I don’t know what would happen to actual proceeds of actual bond issues of actual countries.

But I think I can guess what would happen if there were a panic. Let me assume the deficit limit is the old Maastricht limit of 3% of GDP. Also let me guess that the public debt is 80% of GDP. , Let me assume that investors think that deficits of 4% of GDP are almost certainly sustainable. Finally I assume the State goes along with a 4% of GDP deficit year after year. Finally let me assume all bonds mature in 5 years and pay coupons so that, in the initial equilibrium, their price is always equal to their face value . Unfortunately at time T2 investors suddenly think the state can sustain a deficit of only 3.5% of GDP. There are two possibilities. If the state can credibly commit to running 3.5% deficits, it will. The fact that if more than 0.5% of GDP a year of juior bonds are issued, then they are perceived to be very risky (with the risk strongly concentrated on the marginal bond) makes this a good strategy – even if public spending is very valuable and there are strong Keynesian effects.

If the state can’t credibly commit, then, suddenly junior bonds look very risky – their yield might be so high that the state fiscally tightens to reduce the deficit by 1% of GDP (which, given the multiplier requires budget cuts of more than 1% of GDP). Then Senior bond investors do fine. In fact, because of the budget cuts due to distaste for new junior bonds, junior bond investors do fine.This is severe tightening, but the Greeks would be delighted if they could have such mild austerity. The extremely high returns demanded on junior bonds makes issuing them not at all tempting.

In constrast what happens with ordinary bonds ? If the state can commit to 3.5% deficits it will. But otherwise there can be a vicious cycle in which fear of default causes high interest rates which causes greater fear of default (as occured during the European debt crisis).

The bad equilibrium is made much less bad for two reasons. Old junior bonds (face value 5% of GDP in steady state) don’t dilute new senior bonds. Another way of describing this efect is to say that purchasers of pre T2 issued junior bonds have sold the rest of the world default insurance (a CDS) and their (implicit) payout blocks the vicious cycle. But the main effect is that the 3% rule prevents Treasuries from diluting senior bonds even if they run large deficits. This means that they can run deficits up to 3% of GDP and pay low interest rates, even if no one trusts them.

Note that new the total annual face value of senior bonds issued is equal to 19% of GDP – rolling over the 16% of GDP of bonds which matured plus the 3% deficit. The vicious cycle is largely due to states which have to refinance at higher interest rates to roll over their debt.

This effect absolutely requires the rules for resolution in case of default to be enforceable (which is tricky with sovereign debtors but at least involves judges not politicians).

The reform is also only appealing to a state whose junior bonds are trusted at the time T of the reform. If the first junior bonds to be issued have high yields, they will only be issued if it is absolutely necessary. Junior securities which are only issued if absolutely necessary have huge yields. There is an instant costly spiral. The reform just amounts to strict enforcement of the deficit rule if junior bonds are viewed with great fear at time T.

This means that I don’t think there is any way to make an accountability bond proposal attractive to Italy (I am sure that any junior bonds issued by the Italian Treasury would have a very high yield). My no windfall for current bond holders tranching of bonds proposal is not useful to Italy. I suppose it might be useful to some country somewhere.