The euro zone should combine two proposals for increasing the firepower of its rescue fund -- an insurance model and a special purpose investment vehicle (SPIV) -- according to an EU paper for the mid-week summit obtained by Reuters on Monday.
The paper said neither option would require politically-difficult changes to the existing European Financial Stability Facility (EFSF), which has been approved by national parliaments after some problematic debates.
The euro zone wants to boost the firepower of its 440 billion euro bailout fund without putting more money into it.
With France dropping its idea of turning the fund into a bank to tap European Central Bank funds at a summit this weekend, EU leaders will decide at a second summit on Wednesday which of the two approaches left on the table should be used, with a combination looking increasingly likely.
Under the credit enhancement or insurance model, the EFSF could boost market confidence in new debt issued by a struggling member state by guaranteeing an unspecified proportion of the losses that could be incurred in the event of a default.
This would work via the EFSF extending a loan to a member state, which would buy EFSF bonds in return. The bonds would be the collateral for a partial protection certificate to be held in trust for the state. Both the bond and the certificate would be freely tradable, according to the paper.
If the state defaulted, the investor could surrender the protection certificate to the trust and receive payment from the EFSF. This option does not apply to states already receiving euro zone/International Monetary Fund bailouts as they are no longer issuing bonds on the primary market.
Under the SPIV scheme, one or more vehicles would be set up either centrally or in a beneficiary member state to invest in sovereign bonds in the primary and secondary markets.
Its structure -- the senior debt instrument could be credit rated and targeted at traditional fixed income investors -- is meant to attract international public and private investors, according to the paper.
The SPIV ... would aim 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 with the intention of reducing member states' cost of issuance, the paper said.
The SPIV would be funded by freely traded instruments, such as senior debt and participation capital instruments. The EFSF would also invest in this, and would absorb the first proportion of losses incurred by the vehicle if a state defaulted.
The paper said the insurance option would not work for every member state because some are no longer on the primary market, and also because some have negative pledge clauses on existing debt, which prevent them from granting new security to creditors without granting existing creditors the same level of security.
It concluded that the leverage which can be achieved can only be determined after dialogue with investors and rating agencies.
(Reporting by Matthias Sobolewski, writing by Annika Breidthardt)