Aside : The European Sovereign Debt crisis

So, a deal has been done and the European Financial system has been saved. The markets, in their infinite wisdom, have endorsed it with the FTSE up 3% on the day, everyone staggers back from the breach, breathing heavily. However, I'm not so sure...

The deal seems to as follows :- lenders to Greece take a 50% haircut, which, if it is big enough, is OK as long as it is voluntary so Credit Default Swaps don't kick in; European banks impacted must make a provision for €106bn recapitalisation by June 2012, which is OK as long as they don't do so by reducing credit lines and starve the economy of the investment needed to stimulate growth. No, my issue is with the way in which it is proposed that the European Financial Stability Facility is expanded from its current remaining €250bn to €1tn.

We are told that this will be done in two ways - by allowing investors such as China to invest in it, which is reasonable as long as no-one asks the awkward question "Who won the Cold War, Daddy?", or by using the existing EFSF to provide insurance to buyers of new Eurozone debt in order to drive down the cost of borrowing and make it less risky to investors. This is a fine idea. So fine, in fact, that it was essentially the idea behind the Monoline Insurers, who originally insured American Municipal Debt before expanding into CDOs in the 1990s. The big banks insured their Super-Senior Debt with the Monolines, so that CDOs became theoretically risk-free - that was, until the entire US mortgage market started to implode and the ratings agencies reduced the Monolines' credit ratings ...

So what is different this time? Well, the EFSF is underwritten by countries with AAA credit ratings - like France. If France is downgraded, so is the EFSF and the cost of borrowing goes up. And its only part of the bonds that is insured - the top 20%, the riskiest portion. Needless to say, the financial whizzes have already worked out that both parts of the bond can therefore be priced separately, which negates the point of leveraged insurance in the first place.And then, if there is some general move to default, which is in my opinion would be not only possible but likely if another country heads the same way as Greece, the insurance would not only be inadequate,but would stoke the contagion that would rip like wildfire through the unprotected part of Financial System and leave the Policy Makers with no time for an adequate response.

There is an alternative - for the European Central Bank to print enough money to cover all losses on the bond market. But the consequences of pumping a couple of trillion euros worth of new money into the system would be anathema for a German banker with an inherent fear of hyperinflation. However, sometimes the threat of overwhelming force is what is needed to bring calmness to a situation - the threat of mutually assured destruction has limited the scale of international conflicts over the past sixty years, whilst it wasn't until there was a pair of policemen on every street corner of every city in England (and some exemplary punishments swiftly handed out by the courts) that the riots were calmed this summer. Maybe this is what is required - the threat of overwhelming force to force some sanity in the form of lower costs onto bond markets and to allow politicians some time to put in place policies that may generate the growth that is required to get us out of this mess.

However, as far as I am aware this is not what is proposed. Politicians and Bankers have an interest in talking up the rescue mechanism, but I'm not convinced, and I don't think it will take long before the cracks appear. This is one Equity market rally that I would avoid with a gilt-edged bargepole.