How Safe are European Safe Bonds? An Analysis from the Perspective of Modern Portfolio Credit Risk Models
Several proposals for the reform of the euro area advocate the creation of a market in synthetic securities backed by portfolios of sovereign bonds. Most debated are the so-called European Safe Bonds or ESBies proposed by (Brunnermeier et al. 2017). This paper provides a comprehensive quantitative analysis of such products. A key component of our contribution is a novel dynamic credit risk model which captures salient features of euro area sovereign CDS spreads and enables tractable modelling of default dependence amongst euro members. After successful calibration of our model to CDS spreads, we perform a thorough analysis of ESBies. We provide model-independent price bounds; we consider the expected loss as a function of model parameters and attachment points; we study the volatility of the credit spread of ESBies; and we discuss several approaches to assess the market risk of ESBies. Our analysis provides a fairly comprehensive picture of the risks associated with ESBies.