10/24/2011 02:28 EDT | Updated 12/24/2011 05:12 EST

Document shows eurozone considers 2 options to leverage bailout fund's capacity

BERLIN - The 17-nation eurozone is set to shore up its bailout fund to contain the debt turmoil that threatens to engulf more countries across Europe, and German lawmakers said the plan could boost the fund's lending capacity to more than €1 trillion ($1.39 trillion).

A document obtained by The Associated Press shows the currency zone wants to boost the €440 billion ($600 billion) bailout fund by offering sovereign bond buyers an insurance against possible losses and by attracting capital from private investors and sovereign wealth funds.

Eurozone governments hope that the enhanced European Financial Stability Fund, or EFSF, will be able to protect countries such as Italy and Spain from being engulfed in the debt crisis. To do that, however, it needs to be bigger or see its lending powers magnified.

Leading German opposition lawmakers, who were briefed earlier Monday by Chancellor Angela Merkel on the plan, said the fund's lending capacity will be boosted "beyond €1 trillion" ($1.39 trillion).

But the draft document by the eurozone working group — which Germany's government was sharing with key lawmakers Monday — did not provide a headline figure for the bailout fund, stressing "a more precise number on the extent of leverage can only be determined after contacts with potential investors" and rating agencies.

Because of the move's significance, members of Merkel's party proposed that the change receive full parliamentary approval on Wednesday — although it would have been enough for the parliament's budget committee to approve the plan.

The changes look likely to pass by a wide margin in Germany's parliament.

Lawmakers will vote only hours before an EU summit in Brussels that is set to adopt the new rules for the EFSF.

The enhanced bailout fund rules are meant to guarantee "continued market access of euro area member states under pressure and the proper functioning of the sovereign debt market," the document said.

Therefore the EFSF is set to have the ability to provide investors with a partial insurance against losses from its member states' government bonds, thus making them a safer and more attractive investment.

The eurozone document also foresees setting up one or several special investment vehicles that would partly compensate possible losses on sovereign bonds in a bid to attract outside investors such as sovereign wealth funds, combining "public and private capital to enlarge the resources available."

The draft document stressed that the EFSF would "benefit from the flexibility to deploy both options, which are not mutually exclusive."

The insurance model is designed to increase the demand for newly issued eurozone government bonds, lower the yields, "thereby supporting the sustainability of public finances," the document said.

Lowering the yields for troubled eurozone governments is a key step to counter the widening debt crisis because spiraling yields on debt issued by Greece, Portugal and Ireland eventually cut them off from market financing, forcing the eurozone to provide those nations with an emergency loan package.

In the event of a default, "the investor could surrender the partial protection certificate" and "receive payment in kind with an EFSF bond," the document said, referring to the insurance model.

The new investment facility, a so-called Special Investment Purpose Investment Vehicle (SPIV), is meant to create "additional liquidity and market capacity to extend loans, for bank recapitalization via a member state and for buying bonds in the primary and secondary market," the eurozone draft document said.

Any assistance from the fund for member states, however, would come with tough strings attached and the "appropriate monitoring and surveillance procedures," the document said.

Greece, for example, must implement harsh austerity measures in return for last year's €110 billion bailout.

Beefing up the EFSF is one part of a three-pronged eurozone plan to solve the crisis.

The other two parts are reducing Greece's debt burden so the country eventually can stand on its own and forcing banks to raise more money so they can take losses on the Greek debt and ride out the financial storm that will entail.

Greece's private bondholders agreed in July to accept losses of 21 per cent on their holdings, and getting them to take deeper losses to lighten the country's debt load is proving particularly difficult.

Experts agree that Greece needs to write off more of its debt — German officials have said up to 50 or 60 per cent — if it is ever to make it out of its debt hole.

But many say such a deal with private creditors needs to be voluntary. Imposing sharp losses against the banks through a so-called haircut could trigger massive bond insurance payments that could cause panic on financial markets.

Charles Dallara, managing director of a global banking lobby group currently negotiating a wider Greek debt reduction with eurozone officials in Brussels, cautioned that "there are limits to what could be considered as voluntary."

He insisted that any approach not based on co-operative discussions but unilateral actions would be tantamount to a Greek default, isolating the country for years from capital markets.

"It would also likely have severe contagion effects, which would cost the European and the world economy dearly in terms of employment and growth," Dallara said in a statement.

The European Central Bank, meanwhile, has been taking on the role of firefighter by buying the bonds of financially weakened governments on the open market. That keeps the bond prices up and the rates down, allowing the countries to borrow on financial markets at lower rates than they otherwise could.

The ECB said it bought €4.5 billion ($6.3 billion) in government bonds last week. That was up from €2.2 billion the week before, bringing the total of sovereign bonds held by the ECB to €169.5 billion.

The ECB hopes it will be able to stop the bond-buying program once the bailout fund's new powers are active.


Melissa Eddy and Geir Moulson in Berlin contributed to this report.