An over-engineered solution for Europe?

Never assume the obvious is true - William Safire

Measured on the scale of convolution, the latest bail-out deal for Greece scores a 10.

On the surface, the deal for Greece and troubled sovereigns is a compromise par excellence - there was something in it for everyone, and as such it was two steps forward, one step back for the fans of a fiscal union. Fiscal union, however is a concept that is foreign not only to most individual countries in the EU, but also clearly one which is tests the outer limits of the Lisbon Treaty, if it doesn’t tread beyond them.

The declaration that this was a deal only for Greece was understandable from a political and practical point of view, but in reality it is an extremely dangerous challenge to the market. Greek “exceptionalism” could potentially be the Achilles heel of the deal as it is certainly the weakest moving part of the entire construct.

As I write this, Italian 10-year bond BTP futures are off 30 ticks trading at 103.77 after a morning high of 105.66 in the September future. This is not exactly a ringing endorsement as the market takes a second look after the initial impression.

I could give you my take on the details of the plan - the formation of a European Monetary Fund in President Sarkozy's words – but there are simply too many loose ends here. Still, I would like to make a few key points here:

As always, there are good intentions and certainly a political will to make the debt crisis go away. Full credit give on this account and again a stern reminder to all market participants that European Leaders will do absolutely everything to keep the EU a going concern - something too many fail to understand.

The EFSF is now a de facto special purpose vehicle (SPV) - a vehicle for the 'transfer union' - a transfer union which ultimately only Germany and to some degree France can vouch and pay for.

This is the biggest risk here - the EFSF and the ideas behind it are fine as long as there is no need for it to actually operate to any significant degree. Once bond yields start rising and the Euro is under pressure and the fund starts issuing bonds to pay for its obligations, who is buying the debt? China? The banks under pressure? The US?

Also what is it really the EFSF would be selling? Bail-out bonds for Greece, recapitalization of banks, loans to countries with no access to credit markets? Take your pick, it’s an awfully murky investment for any treasury to add to its portfolio. 

Fitch has already declared a 'silent default' on Greece, but we are awaiting the S&P and Moody's reaction, but more importantly beyond the 'deal relief' of the next few days, what is the political reality?

Merkel went further than her mandate given by the Bundestag and as such could meet serious opposition over the weekend on the home front. Her ratings hit an all-time low last week. This deal, which is the first step towards a transfer union can hardly work in her favour. She will claim she did what is needed to keep Europe intact. She risks strong German voter disapproval.

And German voters are not the only Euro-skeptics out there. Watch to see whether Holland and Finland make noises on whether the EFSF should be extremely limited in the scope of its operations – effectively neutering it. Whether the northern EU members are able to sell this deal to their domestic audiences is the real test – and much more challenging than selling it to the financial markets.

Drawing any major conclusion is too dangerous at this stage, but to me the obvious thing would be to accept this as a deal that has finally altered – as least in theory – the dynamics of the EU debt crisis. It’s too convoluted and contains the awkward Greek exceptionalism component, but offers more realistic relief for the periphery and theoretically increased flexibility for employing the EFSF.

I am however afraid it ultimately will be interpreted as Round Two of moving the debt around - first from the banks to the public under the assumption that a sovereign government would have cheaper and better access to capital markets (which was proved wrong) and now to a supranational European Monetary Fund in effect. The salient danger in this process is that these moves dilute the collateral and widen the gap between the politicians and their electorates.

Through this entire process, free markets continue to take a back seat, as all market returns this year have been driven exclusively by the politicians and their machinations. This deal does not at all change that dynamic, unfortunately, and we wonder what will.