With the old Continent's sovereign-debt crisis barreling into the unknown, every investor, saver and banker should be scared, no matter where they reside. As a big hedge-fund manager told me last week: "We never, ever, thought that countries like Greece or Spain could default. Defaults were the stuff of developing countries like Argentina and Russia."
As the unthinkable becomes thinkable, the European banking system is creaking. Spanish, Italian and French lenders are undergoing the financial equivalent of Chinese torture: a steady trickle of rumors about funding, solvency and reserves.
The more executives protest the institutions' financial health, the less the markets seem to believe them, sending their shares plunging and their cost of protecting against default skyward.
In the circumstances, inaction isn't an option. The broad problem is clear: Bank balance sheets are stuffed full of government bonds issued by the 17 euro-zone governments—courtesy of misguided capital rules that encouraged lenders to gorge on these assets by ascribing zero risk to sovereign debt. As a result, the prospect of defaults by one or more euro-zone countries has scared investors into worrying about the health of the bloc's financial sector.
Any solution will have to break the nexus between sovereign crisis and banking distress. The circuit-breakers being discussed fall broadly into two categories: U.S.-style bank recapitalizations and European Union-wide guarantees for bank debt.
Neither is ideal. A round of equity injections by governments into banks, modeled on the Troubled Asset Relief Program launched by the U.S. in 2008, would be both costly and politically messy.
Unlike the U.S., Europe doesn't have a central repository of cash to be poured into banks. The European Financial Stability Facility, an EU fund with a tongue-twisting acronym and €440 billion in financial firepower, would have to perform that function.
But recapitalizing European lenders to a level that would reassure the markets would take up a huge chunk of the EFSF's resources—some €230 billion according to estimates by Barclays Capital. That wouldn't leave the EFSF with much money for other critical purposes, such as bailing out troubled countries like Greece.
Even if the funds were available, a "European TARP" would lead to an unprecedented nationalization of a large portion of the Continent's banking system. By injecting huge amounts of equity into banks, the EFSF would end up owning virtually all Greek, Irish and Spanish banks, according to Barclays.
This "Europeanization" of the banks would be neither desirable to markets nor palatable to politicians, who would have to explain to taxpayers why they have been presented with the bill for the bailout. Even in the U.S., where TARP went more smoothly than expected, it hasn't been easy for the government to extricate itself from equity stakes in the likes of Citigroup Inc. and American International Group Inc.
If le TARP is too invasive, debt guarantees are mere palliatives. Granted, guarantees—in which the EFSF would promise bond investors to repay them if a lender goes under—cost less than full-blown recapitalizations and only pay out in case of bank failures.
But it is difficult to see how such instruments would lure jittery investors back to European bank debt. And they also would leave taxpayers with the ultimate cost of any rescue, with the added drawback that if a financial institution does go bankrupt, the authorities would have to recapitalize the whole banking system anyway.
There is, however, a third way and it passes through Omaha. Europe should copy the way Warren Buffett buys into companies in times of trouble. In 2008, when Goldman Sachs Group Inc. and General Electric Co. needed cash and a jolt of confidence, the legendary investor demanded nonvoting preferred stock with a fat annual dividend and warrants to buy shares at reduced prices in the future. He recently struck a similar deal with Bank of America Corp.
Translated into Europe, the Sage's playbook could work thus: Ailing European banks would issue contingent convertible bonds, affectionately known as co-cos, to European authorities, and, crucially, private investors.
The bonds would pay a big annual interest to entice buyers as well as carrying the promise that they will convert into equity if banks' capital falls below a specified level by, say, 2013.
This approach would achieve two symbiotic aims. It would enable EU institutions to support banks without having to own them. And it would offer investors a belt-and-suspenders approach: a tasty dividend every year and free equity if banks' capital levels slip.
Banks and their shareholders, who are at risk of being diluted if the co-cos convert, might not like the idea of diverting profits to pay outsiders but, then again, beggars can't be choosers.
A more relevant question is whether investors would participate in such a plan. Unwilling to take my own word for it, I asked two fund managers—one from a savvy hedge fund and another from a large bond fund.
"With a big dividend, I would go for it," said the hedgie. "If the governments are in and there is the prospect of conversion, there is money to be made here." The bond-fund honcho also sounded positive but, being less outspoken, muttered something about being adequately compensated for risk.
Coupled with other programs—namely the provision of day-to-day liquidity from the European Central Bank—the "Buffett recap" might be the best way to avoid a ruinous credit crunch in Europe. Now all we need is action. Being Europeans doesn't mean that we can hide behind a Gallic shrug or a Mediterranean mañana.