Reality Bites: 3 biggest holes in Europe's debt deal

Hole #1- The bigger the better… According to Fortune, the first big hole in the plan seems to be a lack of firepower behind the rescue effort. The European bailout fund, the European Financial Stability Facility, is set to get larger in the plan thanks to some clever financial engineering, going from 440 billion euros to around 1 trillion euros. The fund would be levered up by offering a kind of state-sanctioned risk insurance on euro zone bonds, which would cover the first 20% of losses if it defaults. It should be noted that this is for new bonds, not existing bonds already in trouble. The second objective would be to arrange a special purpose vehicle to help the private sector buy bonds.

Sure, a trillion euros seems like a lot of money, but it can be spent very quickly given the large scope of the crisis. The markets seem to be very worried about the fund's ability in propping up the Italian and Spanish bond markets. The ECB took emergency action in August to keep those markets functioning by intervening directly in the secondary bond market. In just three short months the ECB has had to purchase a whopping 170 billion euros of Italian and Spanish debt. The deal announced last week would have the ECB transferring those bond-buying duties to the EFSF. Without the ECB back, it is clear how quickly that 1 trillion euros can be soaked up.

Hole #2 - As good as your credit That leads to the second big hole in this plan: Credit worthiness. The EFSF will issue bonds that are ultimately backed by the credit ratings of the 17-member nations of the euro zone. Since euro zone countries can't print money like the ECB can, the bond's credit worthiness will be based solely on the fiscal outlook of the member nations. That's scary given the economic outlook for the euro zone. Eurosat announced this morning that unemployment in the euro zone broke into the double digits at 10.2%, surprising analysts. Unemployment in Spain rose the fastest at 0.4% to a mind-blowing 22.6%.

Hole #3 - Greek haircut The last major hole in the deal is surrounding the Greek haircut. The deal calls for banks to accept a "voluntary" 50% haircut on their Greek debt. How this would be accomplished wasn't explained but it would probably force banks to swap their current bonds for ones that have a long maturity. While there has been some agreement with banks over the massive 50% haircut, nothing is official, so they can still refuse to participate. Without strong buy-in from the banks, the deal could trigger a credit event that could set off Greek credit default swaps. That could crush banks and hedge funds that are long Greek debt….

Read more at http://finance.fortune.cnn.com/2011/10/31/european-debt-deal-holes/?iid=SF_F_Lead