Umberto Cherubini University of Bologna

1. Umberto Cherubini University of Bologna

2. Papers Baglioni A. – U. Cherubini: Marking-to-Market Government Guarantees to Financial Systems: An Empirical Analysis of Europe, http://ssrn.com/abstract=1715405 Baglioni A. – U. Cherubini: A Theory of Eurobonds, work in progress

3. Outline Motivation Lessons from the crisis Banks and the public sector in the crisis Mark-to-market of Government guarantees to the financial systems Probability of a systemic crisis Actuarial value of Govt insurance of a financial crisis Theory of Eurobonds A structural model of public debt An example of Eurobond financial engineering Effects on public debt cost of Italy and Spain

4. Crisis stages • Credit crisis: “subprime” mortgages were the trigger of the crisis. • Counterparty and liquidity risk: no trust in neighbours, no trust in assets (main theme of the crisis) • Accounting transparency crisis: fair-value accounting has been a vehicle of contagion, “lite accounting” (borrowing through SIV) • After Lehman default, the crisis moved from the banking system to public balance sheets. Lehman was like a nuclear experiment. The effects of the explosion have not come to an end yet. • Some are considering a new nuclear experiment with Greece. This would bring the crisis back to step 2 above.

5. Where did the crisis end? • The crisis could end nowhere but in the only balance sheet that is not computed at fair value, namely Government and municipal entities balance sheets. • Bail-out from the Government: special purpose interventions (see AIG, Fortis, and the like) and general purpose committments • Central bank intervention: quantitative easing, to provide liquidity to the system and prevent contagion.

6. “Monstruous siamese brotherhood”? • In the aftermath of the 29 crisis the most famous Italian banker, Raffaele Mattioli, founder of COMIT (BCI) denoted “mostruosa fratellanza siamese” the evolution of the relationship between banks and corporate clients. The “physiological symbiosis” typical of “universal banking” (that is lending and providing risk capital) had brought, in a period of credit crisis, the banks to take control of industrial firms. • Today, the same “monstruous siamese brotherhood” is looming in the relationship between Government and the banking system.

7. The “siamese brotherhood” • Banks have exposures to Government. Once monetary base was directly created by the central bank by lending to Government. Now lending is intermediated by banks. Government issue securities that are bought by banks in the primary market and placed as collateral with the central bank. Default of a Government would severely jeopardize the banking system. • On July 13 we will have the results of new stress tests of the soundness of the banking system in front of a public debt crisis ending with default. The old stress test tried in September was only based on the value impairment of a crash in the public debt securities market.

8. Fail or be rescued? • The other face of “siamese brotherhood” is the implicit guarantee offered by the Government to banks • Too big to fail (or to big to save?). The debate is about whether it is possible to allow big institutions (systemically important financial intermediary, SIFI) to go bankrupt • Taxation on SIFI: they would pay for insurance from the public. Pros: makes moral hazard more costly. Cons: who is SIFI? Any volunteer? • Living wills: should (or could) big banks prepare their own funeral? Pros: higher recovery. Reduces moral hazard because makes default credible. Cons: how to plan externalities? Can you be credible if you state that you will walk into the grave on your own?

9. The value of the guarantee • Dataset. Banks from 10 European countries taken from the sample of the stress test of last September, and for which we recovered CDS quotes • Methodology: we filtered the systemic component for each country and we computed the value of CDS insurance (paid upfront), that should be paid by each country to buy protection against a systemic crisis.

10. Marshall Olkin copula • Marginal survival probabilities • P(1 > T) = exp(– (1 + 12)(T – t )) = u1 • P(2 > T) = exp(– (2 + 12)(T – t )) = u2 P(1 > T, 2 > T) = u1u2 min(u1-1 u2 -2) with i = 12 /(i + 12) • This is known as Marshall Olkin copula • If i =  for all i, this is called exchangeable Marshall-Olkin, or Cuadras-Augé copula

11. Marshall-Olkin factor model • The idea of Marshall Olkin distribution is that different shocks bring about defaults of subsets of names. • The problem is that there may exist an arbitrarily large number of shocks and this makes calibration of the model very difficult. • Factor model specification

12. Cuadras-Augé Filters • Call m the cross-section average intensity • Given 1/ (average of inverse Kendall’s ) and 1/ (average of inverse Spearman’s ).

25. The Government crisis, finally

26. Solutions of Government crisis • ESM (European Stability Mechanism): will start in 2013, substituting EFSM. Dimension, 700 billions, for 500 billions interventions. 80 billion paid in cash required (half paid in 2013, the rest in annuities) • New stability pact: designing a road-map to debt reduction, on top of the 3% budget deficits limit, that represented the old stability pact • Eurobonds: substituting part of the domestic debt (40% or 60% of GDP) with European debt, senior with respect to the domestic one, and jointly guaranteed by the Governments of the Euro area.

27. A theory of Eurobonds • The Eurobond proposal is based on three ingredients • Seniority: in case of default Eurobonds are impaired only after domestic debt (junior) is swept away • Cross-guarantee: Eurobonds are guaranteed by all Governments of the Euro area • Diversification: if primary surpluses are not perfectly correlated, budget crises in some countries may be balanced by surpluses in others.

28. Effects of Eurobonds • Assume Eurobonds are designed so that they are default free (we will see later how) • Effects will be: • Decrease of overall cost of debt (due to cross-guarantee and diversification), with no increase of cost for countries whose expected surplus is higher than the European average • Increase of the marginal cost of debt (due to the hierarchical structure). Since domestic debt will be junior with respect to Eurobonds, the cost of domestic debt will be higher than the average cost of debt.

29. A structural model of sovereign debt • Given a path of primary surplus, measured in euros, S, the amount of debt in n years is • At time tN, default occurs if DN > DK, with DK a default threshold (unobserved) • Probability of default at time t0 is P(DN > DK )

30. Mathematics

31. Distance to default • Assume a dynamics of primary surplus. We speficy it in terms of ratio to GDP: si = Si/Yiand di = Di/Yi.Assume a simple model si = s + i, i iid with 0 mean and st.dev.  Then,the distance to default DDN over time horizon tN turns out to be

32. An example of Eurobonds • Financial features of Eurobonds: • 10 year maturity • 40% of GDP (d0 = dk) • Issued at par, with ASW = 0 • Possible credit enhancement features • Cash guarantee (e.g. 80 billion to ESM) • Primary surplus limit (e.g. stability pact)

33. Engineering Eurobonds • Assume a 3% average growth of nominal GDP over next 10 years. Average Europe primary surplus before the crisis was 1.25% with volatility equal 1.23% (average volatility is 1.52%, with primary surplus correlation 81%). • Given these data the distance to default would be 2.445, and the probability of primary surplus paths insufficient to cover Eurobonds interest expenses would be 0.7417%. • Under these assumptions buying protection on a CDS would cost 5 192 € for 10 000 000 €. Adding credit enhancements would reduce this to zero.

34. Credit enhancements • Cash guarantee: assuming the primary surplus data will be in line with history, and assuming an extreme scenario of 0 recovery rate, we compute a value of less than 24 billions (3300 billions of nominal times 0.7234%). • Primary surplus limits: cash guarantee can fail if average future surplus will be different from the historical value (a sort of structural break or Peso problem). However, since the stability pact sets a limit to budget deficit, we could conceive a lower limit to primary surplus to a level of 1.25%.

35. Eurobonds effects: Spain • Assume the Eurobonds in the example are issued to substitute 40% of Spanish debt. • In March, the ASW on Spanish debt was equal to 1.77%. Given our model, we computed an implied value of expected primary surplus of 0.72%. • Given this same primary surplus, if Spain were to tranche 40% of its debt, it would pay 0.363% on senior debt. The impact on the junior debt (which for Spain represents 20% of GDP) turns out to be 4.55%.

36. Eurobonds effects: Italy • Assume the Eurobonds in the example are issued to substitute 40% of Italian debt. • In February, the ASW on Italian debt was equal to 1.15%. Given our model, we computed an implied value of expected primary surplus of 1.34%. • Given this same primary surplus, if Italy were to tranche 40% of its debt, it would pay 2 bp on senior debt (that is less than Eurobonds). The impact on the junior debt (which for Italy represents 80% of GDP) would turn out 1.73%.

37. Policy conclusions • Eurobonds are only a financial instrument that could be used to supply a road map for the solution of the European debt crisis • The road map would need consistent planning and implementation of sustainable fiscal policies (how to achieve primary surplus, what has to be public or private) • Eurobonds would call for renewal of the politics of financial integration. It could be the spur of a new integration path heading towards fiscal policy integration.