It has had to turn to the European Central Bank (ECB) for funding, which is not exactly brimming with money itself. The newspaper El Pais reported that Spanish banks now account for 16.5% of direct ECB borrowing, about double their normal shares. That represents a 26.5% increase over May.

The Financial Times chimed in with the view that the Spanish government's austerity plan is undermining investors' confidence in the potential for the country's recovery. With the Spanish banking system reliant on the ECB, the country's 10-year bond yields rose to 4.67%, which is a whopping two percentage points more than the coupon that Germany pays.

Spain's economy is five-times the size of Greece, so the fact that its banks are reeling is a big deal. This is not something that is likely to go away quietly. Spanish unemployment is north of 20%, its government is slashing spending to get its deficit under control, and public workers are striking in protest - thereby exacerbating the slowdown in output. It's going to be a rocky summer, and most likely not friendly to European stock prices.

Meanwhile, over in Great Britain emerged a story that did not seem to get much play here, but is important. The London Telegraph reported that the Bank of England (BOE) has determined that investors have made a massive options bet on a 20% decline in the FTSE 100, which is the United Kingdom's version of the Dow Jones Industrial Average.

The Telegraph noted that this coincided with a report from the Bank for International Settlements that showed the United Kingdom has major exposure to the Irish and Spanish banking systems, which many fear could be at risk in the next round of the financial crisis. 

Moreover, we have just learned that German investor confidence plunged in June on concern that the sovereign debt crisis would undermine export prospects and crimp growth in Europe's largest economy. The ZEW Center for European Economic Research said its index of investor and analyst expectations, which aims to predict developments six months ahead, slumped to 28.7 from 45.8 in May, according to Bloomberg News. Economists had forecast a drop to 42.

This is a surprising development because the German economy is actually quite strong. Unemployment is down to just 7.7% due to an increase in production to meet booming orders.

"The debt crisis continues to spook investors [because] while the German economy is doing well at the moment, the austerity measures across Europe will hurt exports and growth later in the year," an ING Groep NV (NYSE ADR: ING) economist told Bloomberg.

My view is that we're now in an environment in which there seems to be a real lack of understanding in the United States and Asia about how serious the European funding crisis could become. It reminds me of the way that subprime loan losses were dismissed in late 2007 as too small to worry about - not just by investors and brokerage analysts, but the U.S. Federal Reserve.

If investors are ever made to starkly face the blow-up of a major Spanish bank due to an inability to meet short-term obligations, after blithely ignoring the issue for months, the shock value could indeed create a big 10%-plus dislocation in pricing, otherwise known as the "c word" that rhymes with flash, trash and bash. 

News and Related Story Links:

• Money Morning:
  Are Spain's Banks Better Off than Speculators Would Like to Believe?

• Money Morning:
  Is Europe on the Verge of a Liquidity Crisis?

• Money Morning:
  Borrowing Costs on the Rise as Banks Cope with Contagion Fears

• Money Morning:
  The Sovereign Debt Crisis: Bad For Europe, Good For U.S. Stocks

• Financial Times:
  Bond sales spark fears for Spanish economy

• Telegraph:
  Investors are betting on a Black Monday-style collapse, BoE warns

• Bloomberg:
  German Investor Sentiment Plunges on Debt Crisis

• Money Morning:
  Hungary is the Latest European Domino to Fall

• Money Morning:
  Spain's Banco Santander Stands Strong Against Debt Crisis with Confident Global Expansion

• Money Morning:
  Banks and Investors Both Rattled by European Debt Concerns

• Money Morning:
  Investors See Caution Flags as Spain Bails Out Struggling Savings Banks

• Money Morning:
  The Sovereign Debt Crisis: Bad For Europe, Good For U.S. Stocks