The euro 'solution' solves nothing

You know the story of the euro's new clothes, right?

One day the president of France, the chancellor of Germany and other princes and princesses from countries no one could pronounce -- so they all used initials like EFSF -- declared that they had saved the euro. And they held a big parade in celebration.

All the people in the marketplace laughed and cheered -- while eating and drinking more than was good for them.

Except for one little boy who tugged on his mother's sleeve and said, "Mommy, don't the people see? The euro has no clothes."

The people standing nearby, especially those people who were selling things to the crowd, tried to shush the little boy. "Don't worry," they said. "We just don't have all the details yet."

Yes, as the crowd says, we don't have all the details of the euro debt grand plan announced on Oct. 27. But we do have enough to do some very basic math.

And the math shows that the deal leaves the euro very naked indeed.

The bank haircut is only a trim

The markets can be excused for overlooking some of the math -- the issues are esoteric, and the parties involved are far away from the center of the financial world.

For example, it looks as if the way that the European Banking Authority calculated how much additional capital European banks will have to raise wound up going easy on French and United Kingdom banks and coming down hard on Swedish, Danish and Norwegian banks. That's because the formula for calculating how much capital a bank needs looks at risk-adjusted capital, and the European Banking Authority apparently decided that mortgage-backed bonds are less liquid than government debt -- you know, safe Greek and Italian debt -- and therefore more risky.

Scandinavian banks have relatively large portfolios of mortgage-backed debt, so a bank like Svenska Handelsbanken (SVNLF, news) will have to raise $1.1 billion in new capital while the five big United Kingdom banks will have to raise nothing at all. This, even though the credit default swaps market that insures against bank defaults says Svenska Handelsbanken is among the 10 least-risky big banks in the world. And even when you remember the size of the real-estate bubble and crash in the United Kingdom.

Some of the math is hard, but I suspect the real reason that no one is waving the numbers around is that it might blow up the politics of the whole debt deal. The biggest example of math that no one wants to examine too closely is that of the much-trumpeted 50% cut to the value of European banks' Greek government bonds, which German Chancellor Angela Merkel and French President Nicolas Sarkozy reportedly forced the banks to (grudgingly) accept.

Well, it's already clear that if you keep score the way the banks do, the size of the haircut is going to be a whole lot less than 50%. There's a good chance that the big bank concession to these tough negotiators is going to be close to the 21% haircut the banks accepted in the original Greek debt plan in July.

The way to score this part of the deal is with a financial measure called net present value. Net present value takes into account the fact that money in your hand today is more valuable than money you'll receive sometime down the road. ("I'll gladly pay you Tuesday for a hamburger today," as Wimpy says in those Popeye comics.) It's more valuable because its purchasing power isn't eroded by inflation, because money in hand is certain while promises of money aren't, and because you can reinvest money in hand to earn what might be a higher return instead of waiting for those promises to come sailing in.

So, yes, those bankers will be forced -- excuse me "offered the voluntary opportunity" -- to take a 50% reduction in the face value of their Greek government bonds. But if the new bonds that the banks receive in exchange for the old Greek bonds come with a shorter maturity -- meaning the banks have to wait a shorter time for their money -- the loss measured by net present value will be less than 50%. If the bonds carry a higher interest rate, there's again less loss when measured by net present value. If a sweetener to the deal gives banks some immediate cash payout when they sign up for their haircut, then the net present value loss will be less than 50%.

And one thing we know for certain is that Greek banks, which hold about $70 billion in Greek government bonds, will need about $40 billion to bail them out when the face value of the Greek government bonds they hold is cut by this deal. That's about $14 billion more than the rescue package included in the July deal. (And we do know who will pay that, right? It's not the Tooth Fairy.)