EU Signals Fund Leverage Needs More Talks

By Brian Parkin and Rainer Buergin - Oct 25, 2011 5:00 AM GMT+0700

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Oct. 25 (Bloomberg) -- Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School in Philadelphia, talks about Europe's sovereign debt crisis. Siegel speaks with Susan Li on Bloomberg Television's "First Up." (Source: Bloomberg)

Boosting the effectiveness of Europe’s bailout fund will require further talks with investors as German lawmakers prepare to vote on its new powers tomorrow, a European Union document showed.

While the European Financial Stability Facility can be bolstered under two models that may be combined and implemented “quickly,” the extent to which the fund is leveraged can only be ascertained after discussions with investors and rating companies, the document provided to German lawmakers said.

The draft underscores the gaps remaining in European Union efforts to address the debt crisis as Chancellor Angela Merkel and fellow leaders prepare to return to Brussels tomorrow for a second summit in four days. Leaders are still jousting with banks over the size of losses they take on Greek bonds while deliberating over leveraging the fund after ruling out tapping the European Central Bank’s balance sheet.

“A lot of people will wait to see the detail” of how the EFSF capacity is increased, Kit Juckes, head of foreign-exchange research at Societe Generale SA in London, said in an interview on Bloomberg Television’s “Surveillance Midday” with Tom Keene. “It’s hard to see that the ECB isn’t going to have to print some of this.”

German budget lawmakers are due to convene in Berlin today to begin scrutiny of the two leveraging models. The first would raise the EFSF’s capacity by insuring a fraction of countries’ funding requirements, and the second combines capital from European and non-European public and private investors, the draft said. The two are not “mutually exclusive,” Steffen Seibert, Merkel’s spokesman, told reporters yesterday.

‘Investor Appetite’

“The capacity of the extended EFSF can be enlarged without extending the guarantees underpinning” it, the draft said. Even so, “the leverage which can be achieved can only be determined after dialog with investors and rating agencies around the new instrument, and in the light of prevailing investor appetite over time for the sovereign bonds of particular member states.”

Merkel’s Free Democratic coalition partner indicated support for the revamped fund that should allow it to pass in tomorrow’s German parliamentary vote.

“Two conditions of the deliberations are vital for us: the upper limit of Germany’s 211 billion euros in guarantees can’t be increased and the EFSF mustn’t get a bank license,” Economy Minister Philipp Roesler, who heads the FDP, told reporters yesterday. “These conditions have been retained.”

German Fulcrum

Two years after the sovereign debt crisis came to light in Greece, Europe’s response to the market turmoil once more hangs on German willingness to remain the biggest contributor to euro- area bailouts.

While “little in terms of substantive outcomes” has so far emerged from the deliberations, markets have “continued hope that Wednesday’s summit might eventually cut the Gordian knot of Europe’s debt crisis,” said Tobias Blattner and Chris Scicluna of Daiwa International in London.

The euro advanced and European stocks climbed to their highest level in 11 weeks yesterday. The benchmark Stoxx Europe 600 Index rose 1.3 percent to 242.03 at the close in London, climbing for a second day to its highest level since Aug. 4.

Merkel is pushing for investors to accept losses on Greek debt of as much as 60 percent and for bank recapitalizations of about 100 billion euros, Greens party co-leader Juergen Trittin told reporters after talks with the chancellor. He said the EFSF might be leveraged to “more than 1 trillion” euros.

Greek Losses Compromise

Financial companies, represented by the Institute of International Finance, proposed a loss of 40 percent on Greek debt, said a person with knowledge of the discussions, who declined to be identified because talks are confidential. The EU is calling on investors to forfeit as much as 60 percent, making a compromise at 50 percent possible, the person said.

“There are limits, however, to what could be considered as voluntary to the investor base and to broader market participants,” Charles Dallara, the IIF’s managing director, said in an e-mailed statement. “Any approach that is not based on cooperative discussions and involves unilateral actions would be tantamount to default.”

Greece’s deteriorating finances have narrowed Europe’s room for maneuver in battling the contagion, which threatens to pitch the country into default, rattle the banking system, infect Spain and Italy and tip the world economy into recession.

“Nobody has anything to fear about Europe’s third-largest economy,” Prime Minister Silvio Berlusconi said in an e-mailed statement, defending his government’s commitment to fiscal rigor after the EU urged Italy to pass “comprehensive” measures to fight the debt crisis. The government is preparing to push through “important decisions” on structural changes, he said.

Two Options

According to the document, Option 1 calls for the EFSF to lend a distressed state the money to buy EFSF bonds with detachable “partial protection certificates’’ that can be traded separately from the EFSF bonds themselves, which would be used to collateralize the certificates in the event of a default.

What would constitute a default still has to be decided, the paper says. If a state failed to meet its obligations, the owners of the certificates would be paid off with the EFSF bonds held in a separate trust, the document states.

Using the option would risk triggering so-called negative pledge clauses in the documents governing some of the bonds, according to the draft. A negative pledge forbids an issuer selling new debt senior to existing bonds. The option would also risk increasing the beneficiary country’s tally of debt as reckoned by Eurostat, the EU’s statistical office in Luxembourg.

The paper says Option 2 involves setting up a special purpose investment vehicle, or SPIV, to buy the bonds of the country in question in both primary and secondary markets. The purchases would be funded by the SPIV issuing senior bonds, which would be rated and targeted at traditional fixed income investors. A more junior portion aimed at higher risk investors could also be issued, would rank ahead of the EFSF investment, and share any gains with the EFSF, the draft says.

To contact the reporters on this story: Brian Parkin in Berlin at bparkin@bloomberg.net; Rainer Buergin in Berlin at rbuergin1@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net