John Paulson's Risky ECB Plan Has Misplaced EU Optimism (Update 1)

Updated to reflect Bloomberg interview, ratings updates and added data starting in the seventh paragraph.

NEW YORK (TheStreet) - As a near €590 billion in Spanish and Italian debt comes due in 2012, the market needs a "post-Lehman style firewall" argues John Paulson in Thursday's Financial Times.

Paulson argues that in the next two years, the European Central Bank should guarantee all European sovereign debt and impose a 1% fee on governments for doing so, in a move that he says will lower Spanish and Italian bond yields to levels where they can undergo fiscal reform. It's a bold plan, possibly the riskiest ever for the ECB -- and economists keyed into Europe disagree with it.

John Paulson (Paulson & Co.)

"Unlimited ECB bond purchases or guarantees are not a viable policy framework for the medium-term survival of the euro [and a two year framework as suggested by Paulson is not credible]; a currency in which the central bank has an open-ended commitment to funding governments is one that will ultimately fail," says Tobias S. Blattner a director of European economics at Daiwa Capital Markets.

Debt guarantees by the ECB would be its boldest-ever crisis response, and one that would cut against "no bailout" conventions in the 17-member single currency. The plan is an elegant solution to a complicated problem, if it weren't for political reality and risk.

The disagreement is a signal that even sophisticated U.S. investors may not fully appreciate the fragile dynamics of the eurozone crisis. Like many investors, Paulson's been blindsided in 2011 by renewed concerns of a banking crisis originating in Europe that may spread to the U.S. Paulson invested in banks like Citigroup(C), Bank of America(BAC) and Wells Fargo(WFC), among others in a bold recovery bet just before the onset of the European debt crisis.

As the crisis has escalated, those investments among others, have led to near 30% losses in his "Recovery Fund," according to Bloomberg reports. Paulson apologized for the losses in a November letter to investors.

See John Paulson's portfolio and the video below on stocks to buy in an escalating crisis.

Paulson's European debt crisis naiveté may be emblematic of a misappraisal of the situation across the Atlantic. Overall debt-to-GDP ratios in the eurozone lower than the U.S. may have convinced Paulson of his ECB guarantee solution, which mirrors a crisis-time program adopted by the Federal Deposit Insurance Corporation to guarantee short-term debts, increasing liquidity for U.S. banks. However, looking at Europe's balance sheet as a whole potentially brushes over key EU political and solvency risks. Through a spokesperson, John Paulson declined to further comment on his plan.

For instance, on Thursday, British-born hedge fund manager Michael Platt of BlueCrest Capital Management said on Bloomberg TV that European banks are insolvent as a result of the ECB's inability to respond to the debt crisis adequately.

"It is relatively easy to find solutions ignoring the legal and political constraints that euro area institutions face. Ignoring those constraints, the proposal looks appealing although it also has limitations," says Jacques Cailloux chief European economist for the Royal Bank of Scotland.