Will More Debt Ease Europe's Debt Debacle?

After months of watching Europe fail to stabilize its deepening sovereign debt crisis, financial markets around the world appear to be betting policymakers have finally stumbled upon an answer: creating more debt.

Stocks have rallied this week as Europe has begun debating a plan to create a TARP-styled bailout by using leverage to transform an existing 440 billion euro ($595 billion) rescue fund into a massive fund that could be larger than 3 trillion euros.

“There is a tremendous irony here in trying to solve a debt crisis by creating more debt,” said Ed Yardeni, president and chief investment strategist at Yardeni Research.

Despite the irony involved, some believe using leverage to beef up the European Financial Stability Facility (EFSF) may be the best option to stem the bleeding and prevent the debt crisis there from sending the U.S. to a painful double-dip recession.

Markets Cast Their Vote

“This is really what the market has been waiting for,” said Russell Price, senior economist at Ameriprise Financial. “I think it may be their best hope of providing a solution or a base underneath their problem.”

The markets appear to have thrown their weight behind the idea, which was pushed by U.S. Treasury Secretary Tim Geithner, as stocks rallied during the first half of this week and the cost to insure sovereign debt has dipped.

Before retreating a bit on Wednesday, the stock market in Germany, whose banks hold billions of dollars of Greek’s toxic debt, surged 8.99% in three trading days -- its biggest rally since April 2009.

Likewise, the amount of money it costs to insure against a default has tumbled in most euro-zone countries, except for Greece.

For example, the cost to insure $10 million of Portuguese sovereign debt fell to $1.09 million on Wednesday, down from $1.19 million late last week, according to financial information firm Markit. In Italy, the cost to insurance $10 million of debt declined to $462,000 from as high as $538,000 last week.

‘Bigger Bazooka’

Inspired by the controversial yet successful TARP bank bailout in the U.S., the new plan would leverage the 440 billion of EFSF funds, perhaps by a ratio of 8 to 1. By borrowing against itself, the program would morph into a much more substantial 3.5 trillion euro ($4.78 trillion) rescue effort.

“It’s a bigger bazooka, as Paulson would say,” said Jan Randolph, the director of sovereign risk at IHS Global Insight, alluding to TARP creator and former Treasury Secretary Henry Paulson.

In theory, the more robust fund would then be deployed to buy bonds of debt-ridden euro-zone nations like Greece, Italy, Portugal and Spain. In an effort to prevent a Lehman-style collapse, the money could also be directly injected into the European banks suffering the most from the crisis, mirroring the recapitalization function of TARP.

The markets may be jumping the gun a bit because many of the details of the leverage option still need to be hammered out and, more importantly, all 17 euro-zone nations would need to sign off on the plan. So far, finance ministers in Europe have been much cooler to the idea than the markets and civil servants. Further, several countries still need to approve the stronger EFSF framework, as Germany did on Thursday.

There are also detractors to using leverage to increase the size of the EFSF.

“They’re in this vicious cycle,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “I’m not sure throwing more money at it will be the solution. I think it’s more complicated than that.”

Some are worried about unintended consequences stemming from levering up the EFSF, such as a credit downgrade for France or even Germany, the issue of moral hazard and the fact that leverage tends to exacerbate losses.

“I haven’t heard people focusing on the downside, as if leveraging is free money,” said Chandler. “I thought if anything, we Americans have proven that is not true.”

Fumbled European Response

Still, many have taken the leverage option discussions as evidence that European policymakers may finally take bold and decisive action, something they have been chastised for avoiding by U.S. policymakers.

In fact, the leverage option would be their Plan C, after a May 2010 Greek rescue package and a July 21 strengthened EFSF bailout were largely panned.

“The Europeans are acting like analog in a digital world,” said Chandler. “They aren’t respecting how quick the markets move and how short market patience is.”

The slow, chaotic response is largely due to the nature of the euro zone: it is comprised of 17 very different nations with varying needs and desires.

The debate has centered around a trio of risk burden battles that have pitted the European Central Bank against the EFSF, taxpayers against corporations and rich countries like Germany and France against imploding ones like Greece.

This complex set of competing interests may mean the euro TARP plan won’t ultimately help all countries equally.

“If you believe you have simply a liquidity problem, adding debt to solve a debt problem may help with that,” said Dorsey Farr, a partner at French Wolf & Farr. “If you have a solvency problem, as we likely do with Greece, it’s unlikely to be the ultimate solution.”

That may help explain why the cost to insure Greece’s debt has continued to rise, unlike that of its euro-zone peers. According to Markit, the cost to buy protection for $10 million of Greek bonds required $6.2 million plus $100,000 per annum for a term of five years on Wednesday, up from $6.0 million on September 22.

"Investors seem to believe that policymakers are now more prone to come up with a comprehensive plan to allow for an orderly restructuring of Greek debt and to ringfence contagion effects from such an event," said Otis Casey III, the director of credit research at Markit.

TARP-Styled Rescue

Still, shares of big banks with heavy exposure to Greek debt like French lenders Societe Generale and BNP Paribas have trimmed their heavy losses on the leverage talk.

“Those European banks were experiencing a run” said Price, pointing to U.S. money market funds yanking cash, institutional money fleeing and even domestic cash drying up. “The clock had started. Now is the time. It’s come to a head.”

While ironic to use more debt to fix a debt problem, there is certainly a precedent. Congress didn’t exactly have $700 billion lying around to pay for the 2008 TARP program, which analysts have credited with helping to stabilize the most serious financial crisis since the Great Depression.

Likewise, the Federal Deposit Insurance Corp. was on the hook for billions in losses when it introduced an instrumental 2008 program to guarantee newly issued senior bank debt in an effort to restore confidence in the markets.

“If they can somehow convince the markets this really is a combination of TARP and FDIC style guarantees on bank debt, then it might just work,” said Yardeni. “Let’s face it, things looked awfully grim back in 2008 when we came up with TARP. It’s really just a matter of trust.”