(…) Short-term, disentangling the banking problem could be ugly.
Credit Suisse points out that Spain is the key:
We think the key to the situation is Spain. Spain is key, given that it accounts for 11% of Euro-area GDP (65% larger than Portugal, Ireland and Greece) and that there are $876bn of foreign bank assets in Spain according to the BIS (75% of which are accounted for by European banks, with 40% – around $340bn – held by German and French banks alone). We note that recently CDS spreads have risen to previous peak (with bond spreads not far behind).However, we suspect the situation in Spain is sustainable – and probably will not need to resort to the EFSF. Even despite the recent rise in bond yields…The trouble is that a country whose private liabilities stand at 250% of GDP and whose real estate market has turned to mush may not be so simple to sustain. The FT Alphaville blog cited a Fitch ratings report concluding that Spanish banks are cherry-picking bad loans out mortgage-backed securities they have issued and putting them on their own books. Why take the losses? Because otherwise the securities would be downgraded and no longer qualify as loan collateral at the European Central Bank, which is the only institution that wants to lend money to PIIGS’ banks.
That’s the financial equivalent of a derelict selling blood to buy booze. Spain will have to cut government spending drastically. The trouble is that government is nearly 50% of GDP, so that the economic effect of cuts in government spending and its adumbrations upon the failing real estate market are all the worse.
Each time the European governments announce a new bailout, markets will breathe a great sigh of relief, and each time the bailout gets back into trouble, they will shudder. The bad news is that it won’t work; the good news is that Europe really doesn’t matter that much.
[From European Banks and the Irish Bailout]