European policy makers seem to be headed in the right direction. Magnitude and timing remain uncertain. Today’s talk of a package in the 2 trillion euro area was not confirmed, but it is roughly what the market is expecting.

Since before August the key driver in markets has been the euro crisis. Less than a month ago, in the meetings in Washington around the IMF Annual Meetings we heard senior European officials float a series of ideas that are now part of the plan under discussion. Apparently, some clarity on details should happen this weekend, if not for the G20 meeting by Nov. 3-4 in Cannes.

Is there a consistent plan for Europe? The apparent plan is a combination of bank recapitalization, a harsher Greek debt restructuring, and some credible effort to avoid contagion to the true important risks (Spain and Italy). The three ideas work towards increasing the credibility of efforts to save the euro, but do not address the fundamental problems of the euro. Europe had originally decided to buy time, postpone fundamental institutional reform. Time has just gotten terribly expensive, but an inevitable purchase. Once this crisis is addressed, solving the institutions under the euro is necessary to avoid future similar situations of sharp divergences among countries fiscal and debt dynamics.

Will it be enough? We believe that if those three elements are sized correctly, structured correctly, and potentially accompanied by a few other measures not different than what the US Treasury and Fed had to do in 2008 and 2009, then the answer is yes. Let’s quickly go one by one.

Greece is clearly insolvent, and the July 21^st agreement got rid of the restructuring taboo. Unfortunately, that unprecedented and positive step was undermined by the size of haircut and the restrictions put on it. Now there seems to be more realism, and instead of 21% there seems to be talk of a haircut of 50% or more. As we said many times, the Uruguay 2003 exchange should be the model, in terms of method, as it left everybody better off at the end (see ‘Germany’s Uruguayan steps on Greece‘, and its related articles).

The old European stress tests were not credible because they assumed minimal or no losses from bond portfolios. If it is true that they would now require bank to reach 9% Tier 1 capital under assumptions for bonds very close to current market prices, that would be a huge step in gaining credibility. Then banks have to get capital, or accept government injections (rich countries could recapitalize bank directly, not tapping EU resources – EFSF).

In order to make the claim that Greek is an exception (that there is no plan for other EU countries to restructure in the short-term), there would have to be a safety net for those sovereign debt markets (Portugal, Spain, Italy). Because the size of those together exceeds any rescue fund, there is a need to leverage (EFSF is a set of guarantees by EU countries). Most likely, outright plain vanilla leverage is not feasible, in part because a recent ruling by the German Constitutional Court made it clear that agreements that could generate exogenous jumps in liabilities are not acceptable. Thus, the idea of the EFSF as an insurance agency, taking first losses on debt, say 20-25% first loss. So, 300-400 billion euros from the EFSF used to back such insurance could end up covering almost 2 trillion euros.

The US experience in 2008/2009 shows that a financial crisis (in which banks are questioned), depositors’ fears can only be totally calmed by government guarantees. If we recall, in the US the government guaranteed all money market funds after they ‘broke the buck’.

The ideas are there, politicians seem motivated and working in the right direction. But it is still 17 countries plus multilateral institutions working together towards a massive policy response. There is always the risk of insufficient announcements, lack of details, or longer than expected negotiations between the parts. We see the general direction as positive, but out portfolios remain cautiously positioned.