Flaws in the EU Summit Plan

By Marc Chandler

NEW YORK ( BBH FX Strategy) -- Markets rallied strongly in response to the European developments. Yet it is an exaggeration to think that risk appetites returned as the whole month of October has seen equities, emerging markets, commodities and foreign currencies trend higher, recovering from their neck-breaking, wealth-destroying plunge in September. Still, the advance on Thursday was impressive, helping propel the euro and the S&P 500 through the 200-day moving average, allowing sterling to test its similar moving average and pushed the dollar to yet another marginal new record low against the Japanese yen.

We think the market is getting ahead of itself, but the technical momentum and positioning may allow for an extension of the move. Medium-term investors may need to be patient, but the fundamentals will likely reassert themselves shortly.

This is to say we do not think the European agreement ends the debt crisis and there will be the need for another emergency summit in the not-too-distant future. Exaggerated growth forecasts and inflated privatization revenue projections will require additional adjustments going forward. The agreements in principle still need the details to be worked out, but the broad outline is less than the shock and awe needed to rebuild the lost credibility. At least twice earlier this year, European officials said they would present a comprehensive solution and finally put some closure on the debt crisis. At least twice this year, they have failed and we are not confident that the third time is a charm.

Problems With the Deal

The 50% haircut to private sector Greek bond holders is unlikely to be the last. Even by its own admission, Greece's debt-to-GDP will be 120% in 2020. That is twice the Stability and Growth pact cap of 60%. That is simply not a sustainable solution.

Ironically the European Central Bank purchases of Greek bonds and its refusal to accept a haircut means that the private sector has to take a bigger haircut to reduce Greece's overall debt burden. The market does not know how much in Greek bonds the ECB owns. The guesstimate is 70 billion to 75 billion euros. That is roughly 20% of Greece debt that will not be lowered.

There is approximately another 20% of Greece's debt that is not covered by the scheme; that means that the burden falls to the other 60%. One of the larger holders with about 20% of Greek debt is pensions. Greek pensions, which are thought too largely invested in governments bonds, are going to be halved or nearly so.

The Greek government, the only aid-receiving eurozone country that has not collapsed, is weak and vulnerable. Halving pensions may topple the government, especially if the finance minister and opposition leaders seek a super-majority (180 votes in the 300-seat chamber, while the government has barely secured a simply majority in recent months).

Size Matters

The other two main components of the broad agreement also appear to be smaller than what will ultimately be needed. First, it is not clear yet precisely how the European Financial Stability Facility will be leveraged to 1 trillion euros, but the amount of real capital it has remains limited and leverage implies risk that must be borne by someone. We have seen how the ECB is reluctant to accept the consequences of buying distressed assets.

Second, European officials maintain that European banks need to raise only about 105 billion euros to reach the 9% Tier 1 capital ratio by the middle of 2012. Nearly ever other authoritative estimate, including the International Monetary Fund's, is for substantially more.

Despite the opposition to "too big to fail," European officials do not want banks to sell off assets to reduce their capital needs. There has been talk in the market in recent days that attributed part of the euro's advance to European banks selling dollar assets to reduce their balance sheets and reduce their dollar-funding needs, especially given the actions by U.S. money markets to reduce exposures and tenors to European banks. Some banks, especially French banks, have replaced part of the funding that was provided by U.S. money markets with borrowings from the ECB.

Another irony is that by playing loose with the "voluntary" nature of haircut, policy makers may have undermined the credit default swaps market, contrary to its intent and interest. This could make it even more of a speculative market, even if they can effectively ban naked positions. ISDA says that the voluntary aspect is sufficient to prevent it from triggering the CDS. Therefore the hedge/insurance function of the CDS market is questionable at best.

While undermining the legitimate function of the CDS market, there might be something to learn from the gaming of the haircut/default distinction. A voluntary haircut is nothing more than debt forgiveness. Banks, insurance companies, pension funds lent money to the Greek government. Recognizing Greece cannot pay it all back, they have said they will forgive half of the debt. While entirely self-serving, as mark-to-market would require even deeper losses, and there is the implicit and explicit threat of a hard restructuring, the forgiveness is noble.

To Forgive Is Divine

Many investors/creditors scoff at the "voluntary" participation, but perhaps they would be better served to take the lesson of forgiveness to heart. Forgiveness of some part of the principle of U.S. mortgages that are under water would go a long way toward addressing the debt overhang of U.S. households. With the help of creative officials, holders of U.S. mortgages, including of course Fannie and Freddie, can help create incentives where forgiveness of part of the principle is in their interest.

The European agreement appears to be an attempt to remove Greece as a lightening rod and build a firewall around Spain and Italy. Ireland is regarded as having turned a corner and even the IMF thinks it will be able to return to the capital markets late next year or early 2013. What about Portugal? Why should investors not be asked to forgive it too, not completely of course, but partially?

The twisted logic and perverse incentives are clear. If a country succeeds in implementing the necessary reforms to put it on a sustainable fiscal path, it will be able to service its debt and not require forgiveness. It will be left to labor under its debt burden.

The model for this is not so much a prisoner's dilemma, but a poker game. The one who loses the most in a poker game is not the worst hand. It drops out early. Rather it is the second best hand that loses the most. A country that implements tough austerity may have to pay back its entire debt while a country that does not implement the austerity with the same, can we say, enthusiasm, will see half their debt disappear.

It is not clear what will be the catalyst for the fundamental skepticism of Europe's latest efforts to re-emerge as the key driver. It may be a reminder that the real challenge for Europe is to sustain growth in the face of austerity (like the real challenge in the U.S. is sustain demand despite poor wealth and income growth and de-leveraging). This may come in the form of the Institute for Supply Management reports that point to an economic contraction in the eurozone.

It may come from countries revising down 2012 growth forecasts that require greater austerity to meet budget targets. France will soon officially recognize that growth next year, for example, will not be 1.7% next year but closer to 1%. This will require another 6 billion to 8 billion euros in budget-saving measures.

It may come in the form of a political shock, with Italy and Greece being the more likely candidates.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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