What Happened to the ECB's Heroic Intervention?

Well that was fast.  The Wall Street Journal reports that Italian bond yields are back up above the critical 7% threshhold where interest rates threaten the country's fiscal stability.  But that's not even the worst news.  The same blog post suggests that Spain may be the real problem.  It cites Marc Chandler of Brown Brothers Harriman, who is . . . well, how do you say "bearish" in Spanish?

Spain, unlike Italy, has a housing and real estate bubble. The full magnitude of the cost of this is still unclear. Investors and policy makers have a greater sense of Italy's financial burdens than Spain's.

In the middle of December, for example, the Bank of Spain indicated that bad loans in the Spanish banking system were 7.4% of all loans. This is a 17-year high and is still rising. Property price and house prices do not appear to have bottomed, and the deterioration of the economy, which likely contracted in the second half of 2011 and appears poised to contract in the first half of 2012, warns of the downside risks.

The government fund for bank restructuring (FROB) has already injected 30 billion euros into the banks. The EBA says Spanish banks need to raise another 26 billion in capital in the first half of 2012. Spain's new Economics Minister has indicated that Spanish banks may put aside another 50 billion euros (~4% of GDP) aside for provisions for bad property loans.

Investors' focus has been on the challenges that Italy's largest banks face in raising capital. They have yet to turn the attention to Spanish banks capital needs. ...

Central banks have a pretty dim record defending their currencies from devaluation pressures.  Now we have a new question: can they defend the sovereign debt that's issued in that currency?  In theory, they ought to be able to: just keep buying.  But the European Central Bank isn't buying directly; it's essentially giving European banks free money to buy European sovereign debt.

But one can see reasons that they might not want to buy even if the money is free; it's unlikely that the ECB is literally going to keep doing this forever, which means that eventually, you're going to have a lot of this iffy debt on your books, and no mandatory buyer.

That's even more dangerous if the target countries can't keep their deficits under control.  Whatever you think about Spanish austerity plans, it's worrying that they just announced that their deficit will be more like 8% instead of 6%.  If the government can't do what it says it's going to do now, why will it be able to tomorrow?

And if it can't get things under control tomorrow . . . and if the ECB is not simply going to indefinitely provide free money to buy any amount of debt that the Spanish and Italian and Portuguese governments care to issue . . . why, then, when the music stops, probably someone is going to default, or leave the euro--which is just default by another name, because they will certainly redenominate their debt at a favorable exchange rate which gives creditors a sizable haircut.

And if that's going to happen later, why, then, you probably don't want to buy too much of the stuff now.

So there's reason to worry that things are still shaky.  Moreover, they're kind of running out of things to try.  I suspect that if there's another really big convulsion, it may well be the Euro's last gasp.