Leveraging Explained Europe's Idea for Maximizing the Backstop Fund

How can the reach of the euro backstop fund be maximized without forcing governments to throw more money at it? European leaders are considering a finance tool that would attract private investors and greatly expand the reach of the fund. SPIEGEL ONLINE explains how the "leveraging" would work.

The sums of money involved with the EFSF are jaw-droppingly great.

The sums of money involved with the EFSF are jaw-droppingly great.


It is already an immense sum of money: Euro-zone countries have provided guarantees worth €780 billion to the currency backstop fund known as the European Financial Stability Facility. It has a lending capacity of €440 billion, with which it is to help out deeply indebted members of the currency union.

As large as it is, though, it already appears that the EFSF could in fact be too small. Ten percent of the fund is already guaranteed to Ireland and Portugal. A second bailout package for Greece, currently under negotiation, is also to be funded by the EFSF. In addition, the fund is to buy sovereign bonds from crisis-stricken countries in order to keep their borrowing costs low. But should the euro-crisis contagion spread to a large country like Italy or Spain, the EFSF wouldn't stand a chance.

But euro-zone countries are not prepared to pledge yet more money to the fund. Germany is already on the hook for €211 billion, and parliamentarians in Berlin made it clear in September that they would not back any further increases. Other euro-zone parliaments would likewise block requests for additional funding.

What, then, is a currency union to do? The magic word is "leveraging." Euro-zone leaders are looking for a finance tool which could make the impact of the EFSF as large as possible.

Politicians and finance experts are currently examining a solution which would turn the EFSF into a kind of first-loss insurance. Instead of buying sovereign bonds itself, the plan foresees the EFSF attracting private investors to buy debt from countries such as Greece, Ireland and Portugal. In return, the fund would insure a certain portion of the investment against losses in the event of a partial insolvency.

According to a Reuters report, each country that profits from its bonds being insured would then be required to pay a fee to the EFSF. If all goes well, and the countries are able to pay off their debts themselves, the EFSF could even turn a profit.

How it Works

Currently, euro-zone leaders are discussing the possibility of insuring the first 20 percent to 30 percent of an investment against loss -- similar to first-loss insurance.

Consider the following example, assuming the 30 percent model. A country in crisis seeks to borrow money on the financial markets and issues bonds that guarantee investors a €100 payout once they mature. Instead of buying the bonds itself, the EFSF would make the bonds attractive to private investors by providing insurance against a portion of the losses.

Such losses occur when a country can no longer pay back its debts. While a country is referred to as insolvent in such a situation, investors rarely lose 100 percent of their investments. Instead, a debt haircut is performed -- a portion of the state's debt is forgiven. In the current case of Greece, for example, a debt haircut of 50 percent is under discussion.

Were the EFSF to have offered 30 percent first-loss insurance on Greek bond investments, that would mean that, on a bond with an original value of €100, as in the example above, the EFSF would cover €30 euro of the 50 percent loss. Investors would only suffer a loss of €20 per bond instead of €50.

The insurance model would save vast quantities of money for the EFSF. Instead of buying bonds itself, it would merely guarantee them at a cost of €30 per bond -- but it would insure €100 of financing per bond for the indebted country.

Another Option

According to Reuters, there is also a second insurance model under consideration which foresees a greater investor participation in possible losses. That model would, for example, require investors to swallow the first 10 percent of any losses, the next 15 percent would be covered by the EFSF with the investor being responsible for the rest. Such a model, however, would likely be less successful in attracting investors to buy risky sovereign bonds.

The insurance model had several advantages, first among them being that it would prevent the EFSF from having to buy bonds itself. Furthermore, the insurance model could re-enliven the bond markets, thus resulting in a drop in the interest rates some countries are now having to pay on their bonds. Such a model could be particularly effective when it comes to bonds from countries like Spain or Italy, given that most experts agree that they are not in any immediate danger of insolvency.

Still, even if a leveraging plan were put into place, indebted countries would still be forced to get their finances in order and regain the trust of investors. The insurance model would merely allow them more time to do so.

Despite the attractiveness of such a model, there are risks. Some experts are concerned that the EFSF could guarantee too many bonds or that the risk of insolvencies is being underestimated. They are worried that Germany could, in the end, be forced to foot a much larger bill than expected.

That, though, is a concern the Finance Ministry has attempted to dispel in recent days. The maximum that Germany could be held liable for, said Finance Minster Wolfgang Schäuble's spokesman said, will not rise beyond €211 billion. "That is it. No more. Period."

Discuss this issue with other readers!
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alfredmifsud 10/21/2011
1. Going crazy
Is everybody going crazy? Leveraging whether through borrowing from the ECB under a banking licence or via first loss guarantees, is like putting a nuclear threat right at the heart of the monetary system. What is required is some sense inside the ECB leadership and some co-operation from the politicians to permit the ECB to increase the EFSF through temporary monetisation and through accepting contributions into the EFSF from co-operating countries to build up two trillion EUR of real fire-power without any leverage. The EFSF will than force banks to mark to market all their sovereign holdings and any bank that falls below 9% core capital that cannot raise private capital will be forced (NOT ASKED) to accept recapitisation through the EFSF, This will solve the problem of having EU zombie banks and offers scope for offering deep haircuts to Greece on its debt exposure as a carrot inSIDE the severe austerity package that Greeks have to swallow. At least Greeks could see some light at the end of the tunnel and would no longer suspect that the round after round of austerity is to save EU banks not to save Greece. Unbelievable that the Bundesbank anti-inflation religion is still dominating ECB thinking when the real threat now iS a severe depression not inflation. We have became like Don Quixote fighting windmills.
lakechamplainer 10/21/2011
2. Profits Private
I think I can explain how the "leveraging" via bond sales to private investors will work - any profits will be private and any losses will be public.
Eleos 10/25/2011
3. Fear of the truth
There are only two long term solutions, and long term solutions are the only solutions that dissuade speculators from asking for more. One is printing money to please all but the prudent, with the inflationary consequences to come in a few months time. The other is to force the irresponsible to face up to what they have created, even if it means civil unrest and death. Greece should be told bluntly that it must raise the money to redeem its debt by selling its islands, Italy by selling its art treasures, and the others by selling whatever they have of value. It should be made clear that failing a credible plan to do so Germany will leave the Eurozone. Referenda in the countries concerned with a clear choice put to the electorate should follow. No more kicking the can down the road.
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