The EU Paper Shuffle Continues

The Dow Jones Industrial Average closed up 272 points today, mostly on rumors of an EU bailout plan in the works. As always, the market buys on the rumor, and hopes for good news.

News reports, however, indicate the EU is mucking around with another paper shuffle. The European modus operandi ever since the Greek sovereign debt crisis blew up has been to shuffle and exchange pieces of paper that increase total debt levels without solving problems. Last year, a bailout fund was created, which allowed private sector creditors to ease out of the septic tank while drawing EU member nations and their taxpayers deeper into the muck.

The latest gossip seems to focus on creating a special purpose vehicle, capitalized by the EU bailout facility, which will issue bonds to finance its bailout activities. The funds raised by issuing these bonds will be used to buy up hinky sovereign debt of potential deadbeats among the EU's members.

An interesting feature about these bonds is that they will be useable with the ECB to collateralize borrowings by European banks. This makes the SPV's bonds attractive to EU banks. Those would be the same banks that hold hundreds of billions (or is it trillions?) of Euros of dodgy sovereign debt. By investing in SPV bonds, they'll place themselves in a virtuous (from their perspective) circle where funds they give to the SPV for its bonds will circle back to them as the proceeds obtained from selling toxic debt to the SPV. Stated otherwise, they'll swap snake droppings now stinking up their balance sheets for valuable bonds that can be used as collateral for ECB loans.

It's a very special special purpose entity that, immediately upon inception, is deemed sufficiently creditworthy to serve as an issuer of collateral acceptable to the ECB. Ordinarily, only gilt edged quality securities can be submitted to the ECB for loans. But this special purpose entity is indirectly capitalized by all the EU members, and implicitly is backed by all of them. Of course, no one in a position of authority will acknowledge that the EU's members explicitly or implicitly back the special SPV's bonds. But saddling the ECB with risky collateral could very possibly blow up the entire Euro zone. So, like it or not, the EU would create its own sovereign debt analogue to Fannie Mae and Freddie Mac. Losses from the SPV will land, one way or another, on the good burghers of Northern Europe.

The apparent purpose of the SPV is to be a "bad bank" which scarfs up toxic assets from commercial banks to clean up Europe's banking system. That's not a bad idea, in theory. Such an approach worked in the early 1990s to pull the Scandanavian countries out of a financial crisis. A tough question, though, is who gets to pay Tuesday for the losses that have been sustained today. European leaders have been shuffling and swapping paper since the early stages of the crisis, in the hope that kicking the can down the road would keep the ship afloat until Europe's economies revived and grew enough to produce the wealth to pay for the losses. Unfortunately, Europe's economies, and most of the rest of the world's economies, are slowing or stagnating. Recession may loom. In such a scenario, losses can't be absorbed by economic growth. They have to be allocated among debtors, creditors, taxpayers, or a rich uncle somewhere. Except that there is no rich uncle anywhere--China and Japan might toss in a few nickels each, but not the hundreds of billions needed for a workable bailout. And among debtors, creditors, and taxpayers there is nary a shred of selflessness to be found. This is like a bunch of people at a bar, slyly maneuvering to slip out before the tab comes, sticking the last guy to leave with the bill.

The EU will no doubt try to make the latest bailout sound as elegant and clever as possible. But look beyond all the proposed vehicles, entities, bonds, exchanges and facilities, and focus on who gets stuck with the tab. If the shlemiel won't be able or willing to pay up, then the transaction is just another kick of the can down the road that allows overall debtloads to increase, and pushes the EU farther into the abyss. And right now, no one is bellying up to the bar with a fistful of cash.