In our increasingly interconnected global economy, events around the world can have serious impact here at home. And in the last several weeks, we have seen instability in European financial markets cause volatility on American exchanges. That instability, due largely to Greece's debt crisis, is being addressed in an aggressive and unprecedented way by the European Union and the European Central Bank (ECB).
Still, much uncertainty remains. A core problem is the state of the euro-area government bond market, which is currently focused on the potential for some countries to default on their debts rather than bond yields. That focus has left many European financial institutions holding hundreds of billions of euros in risk assets that were previously considered free of risk. Remarking and recategorizing these assets as risky negatively impacts the ability of banks to hold these bonds, and therefore support the capital needs of some euro-zone countries. To improve the situation, our Institutional Clients Group (ICG) has proposed a new program, reported by Reuters among others, that would help stabilize the European bond market: the European Debt Assured Purchase Agreement program.
The program would use a portion of the resources pledged to the ECB in a highly targeted fashion that would facilitate good-faith bond transactions. It would do this by creating a standardized agreement applicable to a specific issuer of sovereign debt (a country), which in the event of a default, would allow the holder to sell the bond to the ECB at par (face value).
This solution has several important merits as a complement to outright purchases of government securities by the ECB. First, European Debt Assured Purchase Agreements can be channelled to the most unstable part of the current euro-area government bondholder base. Second, they allow current holders to retain their existing bonds or redistribute them in an orderly fashion. Third, the Agreements should help stabilize the euro-area banking system by greatly reducing mark-to-market exposure. The availability of such agreements should attract new cash buyers for the bonds covered by the program. The market would thus function more normally without the ECB intervening as a purchaser of bonds.
Finally, this measure is intended to facilitate secondary market stability, in contrast to third-party guarantees of new government debt issuance. As such, these agreements are not bailouts. When they are no longer necessary, the ECB can simply repurchase them from the market.
European authorities already have made tremendous progress in stabilizing markets. Time is now of the essence, and the authorities should continue to be bold and innovative in working to accelerate the impact of the available lines of support. European Debt Assured Purchase Agreements provide the ECB and policymakers a powerful, transparent and cost-effective tool for use alongside existing mechanisms.