How the Eurozone plans to bury its junk bonds in a big derivative

LAST week’s hotly anticipated Eurozone summit might have been short on details, but it has taken little time for the market’s best financial engineers to concoct their own version of events.

Eurozone leaders announced that they will look into two ways of leveraging up their bailout fund by four or five times – insuring losses on government debt and using their bailout fund to absorb the first wave of losses.

The aim is to turn the €280bn (£246bn) available into some €1 trillion.

Analysts at RBC Capital Markets were quick to explain the mechanics of how this could be achieved.

And it is little surprise that the diagrams they produced (see right) use terms more commonly associated with complex derivatives such as collateralised debt obligations (CDOs) – instruments that many Eurozone leaders have blamed for the financial crisis. What the graphic explains is Europe’s attempt to create its very own CDO or monoline insurer.

The first diagram details how the Eurozone could leverage the European Financial Stability Facility (EFSF), its bailout fund, by insuring creditors against any losses they might suffer as a result of a sovereign default.

Under this model, the EFSF issues bonds that effectively act as collateral as they travel through the diagram. The Facility gives any struggling Eurozone country both a direct loan (potentially for use in bailing out its banks) and some EFSF-issued bonds.

The sovereign puts the loan to use directly, but uses the EFSF bonds to buy insurance on its own debt from a special purpose vehicle (SPV) set up by the Eurozone.

The SPV plays the same role as the collection of US monoline insurers that sold guarantees on assets to investment banks: when a wave of them went bust in 2008, banks were left with worthless insurance.

With the aid of this SPV/monoline insurer, the sovereign can then sell its debt alongside a partial protection certificate (PPC), which guarantees any losses up to a certain agreed amount (hence the “X%” in the diagram).

Those buying the debt are a mix of private investors and the sovereign wealth funds like those of China and Qatar that Europe is keen to lure to the table. The PPC-bond combination allows the struggling state to access these investors, who would otherwise not be prepared to buy its bonds.

If a default occurs and investors need to call in their insurance (using their PPC), they are paid out of the SPV’s resources: EFSF bonds.

So investors have effectively bought junk sovereign debt with a certain level of guarantee from the EFSF.

In the second arrangement, the EFSF acts as the guarantor for a portion of the debt issued by struggling Eurozone sovereigns.

It injects capital into a special purpose investment vehicle (SPIV) that also solicits capital from other investors (both private and sovereign wealth funds) who buy either high or low-risk capital instruments of some kind, possibly bonds paying an agreed level of interest.

This is meant to dilute the riskiness of the sovereign whose debt is being underwritten: in a default, the EFSF is hit first, then the high-risk investors, then the low-risk ones.

Alternative models would see the European Central Bank (ECB) take a central role in guaranteeing any special purpose vehicles.

But current president Jean-Claude Trichet has been staunchly opposed to getting involved and Mario Draghi (pictured), who takes up the post tomorrow, does not appear likely to shift from that stance.

There is a certain irony in the fact that it takes an investment banker to explain how the whole business will work. But if you thought America’s property subprime crash was bad, just pray we can escape subprime two: the Eurozone edition.