UPDATE 1-New euro zone bond seen nearly as safe as German debt: task force

(As more quotes, detail)

FRANKFURT, Jan 29 (Reuters) - A new synthetic euro area bond would be nearly as safe German debt, helping the bloc avert a future crisis and breaking a vicious circle of lending by banks to their national governments, Europe’s financial risk watchdog said on Monday.

Irish central bank chief Philip Lane said packaging government debt into a new bond and selling it off in tiers would give banks an alternative form of liquid collateral.

The top tranche should be immune to all but the worst economic crises, said Lane, who led the task force designing the bond, issuance of which is likely to be years away as regulatory changes will be required.

“We think the senior bond would perform quite well, loosely speaking very close to Germany,” said Lane, who also sits on the European Central Bank’s Governing Council.

“What happens in a severe scenarios?” Lane said, referring to the euro zone’s 2011/2012 crisis. “We think the yield would have been somewhere between Germany and Finland for the senior (trance). “For the mezzanine around Italy and the junior between Greece and Portugal.”

Banks and insurers hold around 3 trillion euros worth of euro zone government debt, now deemed “risk free”, partly to meet a requirements to hold top-rated, liquid assets.

But regulators fear that if a sovereign runs into trouble, its banks will automatically suffer as investors sell off government debt, forcing banks to curb lending and exacerbating economic pain.

Still, any pooled bond is likely to be years away from being created as regulatory changes are still required.

Government debt is now considered risk free on bank balance sheets and for the synthetic bond to be viable, the senior tranche should be treated no worse, so banks wouldn’t have to hold any capital against them.

This would require legislative changes, with proposals up for European Commission debate later this year.

The top 70 percent of the bond would be considered the senior tranche while the next 20 percent would be sold off in the mezzanine trance and the last percent in the junior tranche.

Germany has long opposed a euro zone wide bond, arguing that it could end up paying for other governments’ debt or bailing out the bond issuer in case of market stress.

But Lane argued that the lower tranches would be considered more risky assets and should be sold to investors with higher risk appetite.

“To say let’s rescue a country because some hedge fund holding the junior might lose money is not a very compelling story,” Lane said. “The tranching gives you that protection.” (Reporting by Balazs Koranyi; Editing by Catherine Evans and Toby Chopra)