Wanted in Europe: Bigger bailouts

October 17, 2011, 7:40 PM UTC

By Cyrus Sanati, contributor

The Deutsche Bank Twin Towers, the headquarter...
Deutsche Bank headquarters

FORTUNE — Markets have rallied in the last few weeks amid increased hope that the European debt and banking crisis was nearing an end. Trouble is, the crisis is far from over. The passage of the enlarged euro zone bailout fund last week by all 17 euro zone members is just the first step required to bring any sense of normalcy back to the continental capital markets.

The real hard stuff has yet to be hammered out. European banks still need to be recapitalized, further haircuts are needed on the sovereign debt of the peripheral euro zone nations and the newly enlarged bailout fund needs to get bigger – a lot bigger.

Over the weekend, the finance ministers of the G20, which includes the United States and China, gave Europe until next Sunday to come up with a plan that addresses all of the above concerns in a comprehensive plan. Europeans have accepted the tight deadline, but there still remain deep divisions as to how to resolve these thorny issues. And even if they are successful, there is doubt as to whether such a plan could withstand another round of voting by the bailout-fatigued European populace.

The European crisis has been chugging along for almost two-and-a-half years now without resolution. The market has forced the Europeans to act over that time through a myriad of scares in the bond and equity markets, with the latest flare-up sending stocks tumbling in August and September. But each was met by some short-term fix or promise, which was tantamount to putting a small band-aid over a gushing wound.

The equity markets this morning in Europe extended their greatest weekly gain in the last two years on the hopes that leaders of the euro zone have finally gotten their act together. The centerpiece of this rally appears to be the successful enlargement last week of the European Financial Stability Facility (EFSF) to 440 billion euros ($611 billion). Getting all 17 members to agree to the enlargement took three very long months, in which time the markets were brought to the brink of capitulation on several occasions.

But while enlarging the EFSF was a big step forward to resolving this crisis, it is unfortunately just the first piece needed to complete this complicated economic puzzle. Meeting in Paris over the weekend, the finance ministers and central bank chiefs of the G20 pushed Europe to do much more.

The Greece problem

First on deck is dealing with Greece and its outstanding debt. The 21% haircut on the net present value of Greek bonds outstanding, which was painfully agreed to by the banks and the Europeans earlier this summer, appears to be woefully inadequate. Greece simply cannot afford to meet its debt obligations under the plan given its depressed economy. A haircut of 50% to 60% is now being debated among European leaders, according to people familiar with the situation. There is also talk of simply exchanging the impaired Greek bonds with new bonds issued by the EFSF bailout fund, which would have lower face values.

Both strategies have European banks up in arms. As large holders of the toxic debt, the banks are opposed to further write downs as it could jeopardize their solvency. Greece is of course just the tip of the iceberg. From day one there was fear that once the market relents to a large Greek bailout a domino effect would occur, forcing the banks to take massive haircuts on all their peripheral euro zone debt holdings. The markets have already pummeled the shares of one bank, Dexia, over talk of further write-downs for the banks. The Franco-Belgian bank was forced last week to seek a massive government bailout as it saw its short-term funding pulled by jittery money market funds.

But Dexia is small fries compared to the big European banks like Germany’s Deutsche Bank (DB) and France’s Societe Generale. Those banks hold far more government and commercial debt than Dexia, while being exposed to the same short term funding limitations. The banks fear that any government action, which would force them to slice their sovereign debt holdings, would prompt another sell off in the markets, dragging down every last European bank.

Europe should embrace failure

The European leaders believe that confidence could be restored by forcing the banks to increase their cash on hand from a current minimum of 5% of their assets to 9%. The larger cushion would allow the banks to absorb greater haircuts on their sovereign debt holdings and deflect market skepticism as to their solvency.

The banks are obviously not happy about this. Joseph Ackermann, the head of Deutsche Bank, said last week that forcing the banks to boost capital would be counterproductive and that it would be tough for investors to accept further haircuts on their Greek debt. It’s clear why Ackermann is so upset. Forcing the banks to cut the value of their Greek holdings, while at the same time requiring them to hold on to more of their cash, is hitting the banks’ balance sheet from both ends.

Big bank fix

To stop the bleeding and firmly resolve this crisis, the Europeans need to finally get out their cash bazooka and spray down the euro zone’s banking system. The EFSF was expanded to meet the fiscal funding needs of peripheral euro zone members, which were having a hard time raising debt in the private markets. The EFSF’s mandate and size need to be expanded to include bank recapitalization.

Left on their own, the banks would probably choose to cut back on lending to boost their capital as opposed to issuing new equity or selling assets at fire sale prices. That would hurt an already weak European economy. To avoid this outcome, the banks need to be injected with cash at the same time they are forced to write down the value of their bad debt. The move would ostensibly move all the bad debt from the banks to the government. Over time, it is hoped that the banks pay will pay back the cash, but there is no guarantee they will.

What needs to be done is clearly understood by government leaders. The question of how it will be done is why it has taken this long for them to respond. It would be quite a feat for them to hammer out an agreement by this Sunday, but it is possible. France wants the bank bailout fund to be structured similar to how the Troubled Asset Relief Program was designed in the U.S., where the EFSF is used as the primary funding vehicle to fill the capital holes in the banks. Germany wants the market to help fund the bailout with the EFSF acting as a backstop to any further bank runs. The French model has been tried and tested while the German model would be more palatable to a populace that is suffering from bailout fatigue.

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In the end the French model should win out as the EFSF money is already there and ready to be deployed. The money could be handed over to the various euro zone governments which would then be doled out to the banks. Creating some totally new market-based investment scheme now seems way too late.

In the short term, the 440 billion euros in the EFSF appears adequate to recapitalize the banks and fund fiscal gaps in Greece and Portugal. The IMF estimated back in August that the banks would need 200 billion euros to plug the holes in their balance sheets after writing down their sovereign debt holdings and boosting their capital reserves. While the IMF number was nearly eight times the amount that the European Banking Authority claimed was needed when it conducted its stress tests three months ago, it still may not be high enough. When taking into account a haircut on the debt of Greece, Portugal, Ireland, Italy and Spain at the new calculations of 60%, 40%, 20%, 15% and 10%, respectively, and at the same time requiring European banks to have a 9% capital ratio, the total bailout number swells to 280 billion euro, according to an analysis by JPMorgan.

The EFSF could be used now to wipe the slate clean but it will quickly be tapped out if the banks need further cash or if the revenue shortfalls in the peripheral countries grow. That would leave the euro zone defenseless, which would raise market anxiety. To that end, the leaders will probably need to draw up a plan to eventually increase the size of the EFSF, forcing another round of voting in national parliaments. That could present problems given how difficult it was to pass the current upgrade the first time around.

The market is pricing in a happy outcome in Europe with the EFSF used to recapitalize and stabilize Europe’s banking sector. A resolution that falls short of that outcome this Sunday will put the current market bounce in jeopardy. Eventually, the markets will have to contend with what happens after the EFSF is tapped out. Failure to expand the EFSF could raise anxiety levels once again, putting Europe back at square one.