3 biggest holes in Europe’s debt deal

October 31, 2011, 8:41 PM UTC

By Cyrus Sanati, contributor

Pulling the purse strings

FORTUNE — The magic seems to be fading on Europe’s latest efforts to bring an end to its long-running sovereign debt crisis. The controversial deal reached last week initially sent markets soaring. But a lack of specifics in key areas of the deal seems to be sinking in, putting a real damper on the celebrations. While the plan is a positive step in the right direction, there are a number of holes that need to be filled in to bring about a sustained recovery.

The markets took the weekend to digest the European’s latest controversial rescue plan to save the euro zone and by Monday, investors sent a signal to the Europeans that more is needed. Italian and Spanish bond prices rose, while equity markets around the continent fell, led by large percentage drops in bank stocks. Both are indicators that the market fears further contagion spreading to the big economies of the euro zone, which is exactly what the plan was supposed to quell.

The bigger the better

The first big hole in the plan seems to be a lack of firepower behind the rescue effort. The European bailout fund, the European Financial Stability Facility, is set to get larger in the plan thanks to some clever financial engineering, going from 440 billion euros to around 1 trillion euros. The fund would be levered up by offering a kind of state-sanctioned risk insurance on euro zone bonds, which would cover the first 20% of losses if it defaults. It should be noted that this is for new bonds, not existing bonds already in trouble. The second objective would be to arrange a special purpose vehicle to help the private sector buy bonds.

Both are a good ideas and match similar programs implemented successfully in the U.S. at the height of the mortgage meltdown, but they are still limited to in their size and scope to the principal raised in the bailout fund. The European Central Bank will not be backstopping the fund with unlimited cash, which has made some investors nervous that the EFSF could ultimately run out of money.

Europe takes a page from U.S. bailout playbook

A trillion euros seems like a lot of money, but it can be spent very quickly given the large scope of the crisis. The markets seem to be very worried about the fund’s ability in propping up the Italian and Spanish bond markets. The ECB took emergency action in August to keep those markets functioning by intervening directly in the secondary bond market. In just three short months the ECB has had to purchase a whopping 170 billion euros of Italian and Spanish debt. The deal announced last week would have the ECB transferring those bond-buying duties to the EFSF. Without the ECB back, it is clear how quickly that 1 trillion euros can be soaked up.

As good as your credit

That leads to the second big hole in this plan: Credit worthiness. The EFSF will issue bonds that are ultimately backed by the credit ratings of the 17-member nations of the euro zone. Since euro zone countries can’t print money like the ECB can, the bond’s credit worthiness will be based solely on the fiscal outlook of the member nations. That’s scary given the economic outlook for the euro zone. Eurosat announced this morning that unemployment in the euro zone broke into the double digits at 10.2%, surprising analysts. Unemployment in Spain rose the fastest at 0.4% to a mind-blowing 22.6%.

Moody’s issued a warning last week that the EFSF plan is a “negative” for the nations in the euro zone that have a triple-A credit rating, since it will ultimately be their tax dollars that will be counted on to hold this entire bailout together. The “negative” warning from Moody’s (MCO) could lead to downgrades in some countries, which would increase their cost of funding, plunging them further into debt. This is especially a concern for France, which has an unemployment rate of 9.9%. S&P said last week that the country is already in danger of losing its triple-A rating as a result of its weak fiscal situation. The loss of that rating, which is widely expected to occur when France comes up for review by S&P in December, will mean that the EFSF bonds could take a credit rating hit, forcing the Europeans to offer a higher yield to attract investors.

This all may be a moot point if S&P follows through with a promise that could crush the EFSF entirely. Earlier this summer, the credit rating agency said that any “combined credit facility” would carry the rating of the lowest, not the highest, member contributing to the fund. Since all 17-members are contributing, including Greece, the bonds should have a junk credit rating. The Europeans are in talks with the ratings agencies over this key issue, but no agreement was forged last week.

A junk rating may not be an issue if foreign governments just snap up the bonds in a show of solidarity with Europe. But while China has said it would consider investing in the EFSF, other nations like Brazil, Australia and Russia have stayed mum on the situation. Until there is more clarity on the credit situation, this deal remains locked.

Greek haircut

The last major hole in the deal is surrounding the Greek haircut. The deal calls for banks to accept a “voluntary” 50% haircut on their Greek debt. How this would be accomplished wasn’t explained but it would probably force banks to swap their current bonds for ones that have a long maturity. While there has been some agreement with banks over the haircut, nothing is official, so they can still refuse to participate.

The 50% haircut is massive and will force banks to raise capital at a precarious time. Without strong buy-in from the banks, the deal could trigger a credit event that could set off Greek credit default swaps. That could crush banks and hedge funds that are long Greek debt, creating a potential financial panic. But it is hard to tell which banks are long Greek debt and which are shorting it. That is helping fuel the drop in European banks stocks today.

In addition, the plan hopes to bring the Greek debt to GDP ratio to around 120% by 2020. That is still a really high level of debt and excludes the possibility that the Greek economy will get worse. Banks could ultimately need to write off all that Greek debt if the country is unable to get their act together. Further weakness in the Greek economy could also lead to cascading defaults of private loans, threatening to bring down many European banks that issued private loans to the Greek public during the boom years.

There are many things to like about the European plan, but there are still too many unanswered questions. The markets seem to be sobering up to that reality today. Until the Europeans get specific and fill in these holes, volatility will continue in the markets.