It’s time for a European TARP

July 15, 2011, 4:45 PM UTC

FORTUNE — Investors are pushing the panic button as the European debt crisis spins out of control. Banks around the world are trying to calm their clients’ fears, setting up special conference calls and one-on-one sessions, but there seems to be nothing they can do at this point to prevent a rush for the exits.

While analysts acknowledge that the problem is severe, they also believe that there could be a way out of this mess, with some calling for a massive European bailout mechanism, similar to the one set up in the U.S. at the height of the financial crisis. Most agree that European governments need to act collectively and in short order, before this contagion causes irreparable damage to the economic fabric of the continent.

Each passing day seems to bring more sour news out of Europe. On Monday the yield on 10-year Italian sovereign bonds jumped from around 4% to 6% as investors dumped Italian debt. Moody’s later downgraded Ireland’s sovereign debt to below investment grade, or junk, sending yields on their 10-year bond to a record 14%.

Brokers and investment advisors are trying to assuage their clients’ fears, but most portfolio managers just want to dump anything associated with the peripheral countries of Europe. Things have gotten so bad that it now costs more to insure the sovereign debt of Portugal and Ireland using credit-default swaps than it does to insure the debt of Venezuela.

The threat of contagion has emerged as a “clear and present danger“ in the European fixed income market, a senior manager at Credit Suisse told investors on a special fixed income conference call Wednesday. “Our view is that this issue needs to be tackled aggressively and soon by authorities to avoid a real threat to global financial stability and growth.”

Band-Aid solutions

The Europeans have been trying to manage the sovereign debt crisis for over a year now with only marginal success. The policy has been to treat the symptoms of the contagion rather than to find a cure for it. That methodology might have worked for a few years if they only had to contend with bailing out Greece, Portugal and Ireland. But now that the crisis threatens to take down Italy and its 1.8 trillion euros ($2.6 trillion) debt pile, the Europeans need a more lasting solution.

Analysts and investors feel that the time has come for the Europeans to face the music and decide how far they are willing to go to preserve their monetary and political union.

Will Europe choose stronger political and economic integration or will it choose disorderly disintegration? The current crisis illustrates that fiscal decisions made at the state level need to be in harmony with monetary decisions made by the EU central bank. To achieve this balance, nations in the eurozone would need to give up sovereign control over much of their economy – something that in the past was unthinkable.

But the bailout packages for the peripheral eurozone nations have in essence done just that. To get the loans, Greece and Portugal had to meet certain fiscal targets by cutting spending and selling off assets. The “core” European nations, namely France and Germany (along with the IMF), are now essentially calling the shots in the peripheral nations, which is tantamount to a temporary transfer of sovereignty. Investors would like this temporary economic arrangement to become more permanent, thus requiring the eurozone to come together in a much stronger political and fiscal union – no easy task.

But it’s unclear if the Greeks and Portuguese are willing to have nearly all their state-level decisions made by foreigners in Brussels and Frankfurt forever. And it’s equally unclear if the Germans and French are willing to permanently merge their balance sheets with those of the peripheral countries.

Investing in eurobonds

For now, the current European bailout fund needs to be greatly expanded in both size and scope.

The plan being floated around the halls of Frankfurt at the moment calls for the rich countries in Europe, namely Germany and France, to issue some sort of collective bond to help pay off the debt of the peripheral countries.

The European Financial Stability Facility (EFSF), set up last year when the crisis first flared up, currently issues debt to help fund the bailouts of the peripheral countries, but doesn’t buy up their existing debt in the secondary markets. For this new plan to work, the EFSF’s role and its 750 billion euro mandate would need to be greatly expanded, something the Germans this week reluctantly acknowledged could happen.

The EFSF would create a new “Eurobond,” as Credit Suisse (CS) is calling it, to help finance the acquisition of billions of euros worth of peripheral sovereign debt held by private investors. Those investors looking to get rid of their peripheral sovereign paper would now have a willing buyer in the EFSF.

Such a funding mechanism would work similar to how the Troubled Asset Relief Program, or TARP, worked in the U.S. at the height of the financial crisis. But instead of buying bad mortgages off the books of crippled banks, the EFSF would buy bad sovereign paper. The price at which the EFSF would pay for the debt is controversial, but most see it paying the current market price for the bonds, which is below face value. The EFSF would then forgive the difference in the value of those bonds, essentially giving the peripheral nations a haircut on their debt, allowing them time to get back on their feet.

All this sounds good in theory, but it may not work in practice. Investors may be reluctant to give up their bonds at distressed market prices. Meanwhile, there is no guarantee that the new eurobonds would attract enough investors to fund the buybacks. Investors would be more willing to fund this new debt transfer from the periphery to the core if they knew with certainty that fiscal discipline was the new norm in Europe. For that to happen, Europe will need to get closer than ever.

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