Independent Investor: Europe — A Train on the Right Tracks

It finally looks like the European Union is on the right track. After almost two years of vacillating, finger pointing and empty promises, the outlines of a deal were announced this week in Brussels that could provide a solution to Europe’s debt crisis.

The EU gave itself a self-imposed deadline of this Wednesday to come up with at least an outline of a deal. It wasn't easy. There were so many moving parts to include that in the end it took a marathon, ten-hour series of negotiations to get everyone on board.

The respective finance ministers addressed the three areas that most threatened the financial well-being of the Union. Greek debt was the first order of business. Europe's leaders vowed to reduce that nation's debt to 120 percent of GDP versus its present rate of 180 percent. Much of this reduction will be accomplished by asking private creditors (mostly banks) to accept a 50 percent loss on the Greek bonds they hold. It remains to be seen whether these financial institutions will cooperate, but governments have historically managed to get what they have wanted from the private sector (or else).

This 50 percent "haircut" is equal to roughly $139 billion, which will be applied to a second rescue plan for Greece. The Euro leaders promised to guarantee the remaining half of Greece's existing debt and will spend as much as $42 billion to insure against further losses. It will take at least another two or three months to finalize this debt deal.

The next issue, of course, was how to mitigate the big hit Europe's banks are going to take in this haircut. The losses they will incur will drastically lower their reserves and the major concern was how to replenish these reserves quickly. The banks have been directed to go out into the open market and raise as much as $148 billion between now and next June.

Of course, the devil is in the details. There is no guarantee that there will be an appetite for new European debt or equity offerings. Still, depending on the terms, there may be demand from countries such as China, Brazil or in the worst case, European governments themselves that may be buyers of last resort if push comes to shove.

The EU recently agreed to establish a European Financial Stability Facility and fund it with $610 billion. Somewhat akin to the U.S. TARP, the ESFS is a bailout mechanism, only instead of baling out banks, the money was earmarked to save countries like Italy, Portugal and Greece.

The problem was the EFSF is just too small to insure the debt of bigger countries. There was a need to leverage the fund in order to insure at least part of the debt of borderline economies like Italy and Spain. The ministers agreed to allow the ESFS to act as a direct insurer of bond issues, which will bring the total firepower of the fund up to $1.39 trillion. This should make new bond offerings by Italy and Spain more attractive to investors, according to the EU.

There is also an effort to entice big institutional investors from both the private sector as well as government sovereign funds to contribute to a special fund, backed by the EFSF, which could be used to buy government bonds as well as to help in the recapitalization of Europe's banks.

I admit there are still a lot of details to work out but the Europeans should get an "A" for effort in finally addressing the core problems of their financial crisis. I do believe that implementing this program will take time. The process will be less than perfect and that could mean more disappointment ahead, but at least Europe is on the right track at last.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net . Visit www.afewdollarsmore.com for more of Bill's insights.