Europe takes a page from U.S. bailout playbook

October 26, 2011, 8:30 PM UTC

By Cyrus Sanati, contributor

FORTUNE — The big solution to Europe’s long-running sovereign debt crisis was supposed to be unveiled today. But instead of a solution, the Europeans have managed to give the markets another dose of uncertainty. The result will be continued market volatility that threatens to bring about long-lasting damage to the world economy.

The solution to the euro zone’s current problems is no secret – it’s getting the Europeans onboard that’s been the problem. The key now is to restore confidence in their debt market to prevent contagion spreading from the small peripheral countries to the core euro zone economies. To restore that confidence, they know that their bailout fund, the European Financial Stability Facility (EFSF), needs to be much bigger in size and scope.

The expansion of the EFSF was approved in the summer and finally came into force this month following agonizing votes in all 17 euro zone member parliaments. Trouble is, at 440 billion euros, the newly expanded fund still doesn’t have enough firepower to quell the markets and restore investor confidence. That figure was the “big bazooka” number in dealing with potential defaults in Greece, Portugal and Ireland. But the crisis has since spread to Spain and Italy, which have much larger economies, and therefore requires a much larger bazooka.

How to expand the EFSF again is at the heart of the troubles vexing European leaders. Getting all 17 members to agree again to put more capital into the fund after they just voted on an expansion is seen as a near impossibility. Getting them to agree to a bailout fund of around 2 trillion euros, which many believe is the new magic number after factoring in possible defaults in Italy and Spain, would be like convincing the president of France to serve Kraft singles for a cheese course at a state dinner.

A Band-Aid fix: Leverage

So instead of augmenting the principle of the bailout fund, the Europeans have decided to artificially inflate the number by levering it up. How they propose to do this is the newest controversy in this long-running drama. A very rough draft communiqué on the issue made the rounds yesterday. It laid out two options that they believe could expand the firepower of the bailout fund without committing any more money from member states.

The Europeans would probably never admit it, but the two proposed leveraging tactics look very similar to two programs instituted in the U.S. at the height of the mortgage meltdown in 2008 and 2009– the Term Asset-Backed Securities Loan Facility, known as TALF, and the Public-Private Investment Program, known as PPIP. Remember those?

Here’s a refresher. TALF set out to encourage investment in securitized assets that were seen as sound but that no one wanted to touch, like high quality triple-A asset-backed securities. The government would guarantee the first portion of losses to encourage private investors to jump back in the market. PPIP set out to encourage investors to buy up troubled assets off the banks’ balance sheet by essentially loaning them around 85% of the money to do it. Both programs had the effect of augmenting the firepower of the U.S. bailout fund, known as TARP, by having the private sector help with rescue efforts with government incentives.

The European proposals are similar to these programs. One would create a special purpose investment vehicle to help fund asset purchases — in this case, presumably, high-quality sovereigns (i.e. Italy and Spain). The other would act like an insurance policy in which the EFSF would guarantee the first 20% of losses associated with a sovereign default, creating a quasi sovereign credit default swap. This expands the firepower of the bailout fund by again enlisting private investment.

The Europeans have got the right idea in copying these programs, but the structure they have set up for its implementation is fundamentally flawed. TALF and PPIP worked to get the U.S. economy going again because investors knew whatever money they put in the system was essentially being backed by the firepower of both the U.S. Treasury and the Federal Reserve. This gave them the confidence to open up their wallets to help augment the government’s bailout program.

But under the European plan, the only backstop is the principal in the EFSF. Unlike the Fed and the Treasury, which have revenue streams and basically unlimited money printing powers, the EFSF’s pool of cash is set at 440 billion euros and cannot grow. That is unlikely to spur the confidence necessary to get investors to jump start the European sovereign bond markets and encourage banks to increase lending.

For the European plan to work, the EFSF needs to be backed by the European Central Bank. The firepower of the ECB is the key to this entire puzzle. Investors will be far more likely to commit to helping the euro zone if they knew that the ECB was ready to flood the system with cash if there is a problem. Trouble is, the ECB has refused to help, and countries, like Germany, do not want them to lend their balance sheet out to back up the EFSF.

To be sure, there are no quick fixes to Europe’s debt woes. But that is not what needs to happen right now. Programs like TALF and PPIP, for example, didn’t fix the U.S. mortgage problem, but they are still viewed as being successful. That’s because they helped end the more pressing crisis of confidence, which was threatening to take down the entire U.S. banking system.

The Europeans need to put out the fire before they rebuild their house. While the proposed plan gives them the hose to fight the fire, there still isn’t enough water to put it out completely. Time is running out.