3 Reasons the European Bailout Could Fold Like a Cheap Tent

NEW YORK ( TheStreet) -- The equity markets are rocketing up in jubilation as traders celebrate the European Union's plan to address the continent's banking crisis and put its sovereign debt issues behind it.

But far from solving the issue, the announcement out of Brussels is full of holes, mind-blowing assumptions and downright fiction that will put Europe on a crash course with economic growth and stability for the next decade.

In a research note issued by JPMorgan Chase ( JPM) on Thursday appropriately titled "EU Delivers a Little on a Lot of Fronts," the analyst summarizes the key parts of the deal as:
  • Banks will need to raise capital levels to 9% by June 2012;
  • The EU will leverage up a new China-backed bailout fund to achieve ¿1trillion of lending;
  • A "voluntary" bond exchange with a 50% haircut for privately held Greek government debt;
  • The EU will pursue term funding guarantees for banks.

Each proposals sound rational and it looks like this was exactly what the market wants to hear. Unfortunately, when you dig in on the details, the solution may actually make the problems worse

Here are just three reasons the European bailout will fold like a cheap tent:

3. One Bad Haircut

Have you ever been invited to take a loss? That's what owners of Greek bonds are being offered and it's this unlikely scenario the bailout now hinges on.

According to Thursday's statement, in order to bring down the Hellenic state's debt-to-gross domestic product ratio, EU leaders will 'invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors."

While that's better deal than what would happen if Greece became insolvent, causing a complete loss, those "private investors" that plan to accept the invitation for a 50% haircut happen to be European banks and insurance companies -- the same banks and insurance companies that are already undercapitalized and looking to the EU for a bailout.

It's a big assumption that even a majority of investors will accept a 50 percent haircut on Greek debt. The Institute of International Finance, a cabal of the largest multinational banks has given the deal the green light, but when it comes to booking a loss for your shareholders, some banks could try to pull out at the last minute.

2. A Capital Drop in the European Banking Bucket

Banks in the EU will need raise 106 billion euros ($146 billion) by the end of June 2012 as a way to plug an ever deepening capital hole as part of the bailout deal, according to EU regulators.

"The building of these buffers will allow banks to withstand a range of shocks while still being able to maintain an adequate capital level," the European Banking Authority said in a separate statement on Thursday.

That would be great, if anyone actually believed that European banks only need that paltry amount.

In fact, the International Monetary Fund said just last month that the debt crisis created as much as $300 billion ($410 billion) capital shortfall for European banks that required immediate injections of new cash.

"Without additional capital buffers, problems in accessing funding are likely to create deleveraging pressures at banks, which will force them to cut credit to the real economy," the IMF report said.

It's odd that the EU came up with a number less than half of the IMF's projections since the managing director of the IMF, Christine Lagarde, was sitting in on the EU discussions.

And, of course, either figure does not even take into account the losses the banks will take on the Greek haircuts.

An Offer Investors Can't Refuse

Despite taking a loss on Greek sovereign debt to the tune of billions of Euros, investors that bought protection on the bonds will never be compensated despite this being EXACTLY the situation that they paid to avoid.

The deal will likely kill off any future market in the sovereign protection, and may even undermine the entire bailout.

Billions in credit default swaps (CDS) that were bought by Greek sovereign investors to protect themselves against default will not be triggered because the 50% haircut is considered -- you guessed it -- "voluntary." By swapping their old bonds for new debt with half the coupon, Greek sovereign bonds will not be put into a forced default, an important trigger for CDS.

"Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders," the International Swaps and Derivatives Association said Thursday. "As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts."

Of course, if your definition of voluntary is accept this or else that German Chancellor Angela Merkel or French President Nicholas Sarkozy will look the other way as your bank goes under, that might be impetus enough to take the deal.

It's not unlike when Sonny Corleone described a similar deal his father made in The Godfather.

" My father assured him that either his brains or his signature would be on the contract."

That sounds like a solid way for the European Union to start anew.

-- Written by Christopher Westfall in New York.

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