Fears mount over a proposal to force investors to share the burden of a future financial crisis. Writer Geraldine Lambe

What is it?

A proposal for a permanent sovereign insolvency mechanism for the eurozone, to include a provision that would force bondholders to give up part of their claims.

Who dreamed it up?

Germany. It is being pushed by chancellor Angela Merkel, who believes it is the only way to force investors to help pay for the consequences of a future financial crisis. Ms Merkel is reported as saying that such a mechanism will keep investors and eurozone governments from piling up excessive debt, wean debt-laden countries off bailouts and support the euro.

Other European players have now waded in. The head of the European Financial Stability Facility (EFSF), Klaus Regling, has said that sovereign debt markets are "awash with moral hazard", and French finance minister Christine Lagarde has said that "all stakeholders must participate in the gains and losses of any particular situation".

What are the main provisions?

The new mechanism would replace the €440bn EFSF (set up in June as an emergency measure after the Greece rescue plan and only meant to last for three years), which Germany - the largest guarantor - does not want to extend.

Details are sketchy, but this Chapter 11 for sovereigns could include an extension of debt maturities, an interest payment holiday, a suspension of bondholder rights, or a straight haircut.

What do the politicians say?

Since markets began punishing peripheral eurozone debt, politicians have back-peddled. German finance minister Wolfgang Schäuble said markets had misunderstood, and that Ms Merkel was talking "theoretically".

At the G-20 meeting in South Korea, other European finance ministers said that the proposals did not apply to outstanding debt, and that any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements.

What does the industry say?

Most industry participants think the proposal is mistimed. Suggesting that bondholders will be forced to take haircuts at a time when spreads are ballooning has been likened to tossing a hand grenade into the eurozone periphery.

Like many bond investors, UniCredit's chief economist, Marco Annuziata, is not reassured by assurances that outstanding debt will not be affected. "This is a breathtaking mixture of suicidal irresponsibility and farcical incoherence," he said in a research note.

"If by 2013 countries such as Greece, Ireland and Portugal are still in a shaky position, any new debt will carry exorbitant yields," he added. "The EU would then have to choose between an open-ended bailout, and reneging on the promise that existing debt would not be restructured."

What will it do to Europe's banks?

One banker refers to the proposal as "hare-brained", saying that politicians seem to forget that sovereign bond investors are, in large part, the region's banks. According to figures from Royal Bank of Scotland, about €2000bn of debt instruments from Greece, Portugal, Spain and Ireland are held by banks outside of those countries.

"How can Ms Merkel fail to realise what the proposal would to do to Germany's already fragile banking system?" asks the banker. "German banks hold more than €12bn in Irish bonds, €17.6bn of Greek bonds, €10bn of Portugal's bonds, and €34.3bn of Spanish bonds. Does she have any idea what a haircut would do to them?" he says.

The law of unintended consequences

Another banker argues that it could cause investors to flee sovereign bond markets; and eurozone states must issue ¤915bn in new bonds next year either to roll over debt or to cover big deficits, according to figures from UBS.

"Irish debt is already under pressure in the market, and bond spreads in Spain, Italy and Portugal are widening," says the banker, "but the message being sent to investors is that they must charge a big risk premium on any peripheral sovereign debt that expires after 2013; while there is real confusion over what happens before that date. What if Spain or Portugal need to use the EU's bailout fund next month, or next year?"

Bondholders are already retreating. A Citigroup study, based on data from the second quarter, reveals a sharp drop in foreign ownership of debt from Greece (-14%), Portugal (-12%), Spain (-8%) and Ireland (-5%).

Could we live without it?

A mechanism for sovereign default is sensible. And few can deny that investors should share the burden with taxpayers. But the middle of a sovereign debt crisis, with a wall of debt to be refinanced, is not the time to spook investors.

Good idea, bad timing


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