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. 

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"Banks and those that run them have no incentive to come clean over the scale of losses within the housing market, Spain is currently a kind of anti-market," Jonathan Tepper, chief editor at an economic research and analysis company, told CNBC.

Now the Bank of Spain is encouraging savings banks to merge to prevent company failures. This bailout is seen as a warning to other banks that they could face a takeover by the central bank if they do not follow through on acquisition opportunities.

CajaSur, formerly run by the Catholic Church, voted earlier Saturday against a merger with the larger savings bank Unicaja. CajaSur's board of directors consisted mostly of priests who wanted to avoid a decision resulting in heavy lay offs.

But CajaSur lost $748 million (596 million euros) last year, and its dire financial position prompted the Bank of Spain to step in hours after the board's vote.

"All the regional governments should be aware that decisions have to be made quickly," said Spain's Finance Minister Elena Salgado. She said the central bank has shown "firmness, control and solvency."

This is the first seizure financed by the Fund for Orderly Restructuring of the Spanish Banking System (FROB). The government's policy gives banks until June 30 to apply for the fund's support. The state's cost for propping up the failing banks is estimated to grow to $43 billion (35 billion euros), at a time when Spain just announced an $18.76 billion (15 billion euro) austerity package.

There are 45 savings banks in Spain and the government wants to see that number cut to around 20. At least 16 are currently in merger talks.

CajaSur represents just 0.6% of Spain's banking industry assets, prompting some to think this takeover will not hurt Spain's economy and could trigger the much-needed merger activity among small savings banks.

"There are foreign investors who are negative on Spain for whatever reason, but this is a relatively small bank," Alberto Espelosin of Spain's Ibercaja Gestion, told Bloomberg. "I prefer to see it as something positive because it is the start of a process of restructuring of the banking industry which is very necessary."

But others say the government's policies are not good enough to stabilize the banking industry.

"Current policy is to take one good bank and merge it with a bad bank in the hoping of getting an average bank," said Tepper.

The lending abilities of these "average banks" coupled with the added bailout expense to Spain's government are making investors nervous.

"It has refocused people's attention on the bigger picture question of whether or not this is merely a sovereign debt issue or something more systemic across Europe and potentially across the broader financial system," Craig Peckham, equity trading strategist at Jefferies & Co., told Reuters.

Spain's banks were all down Monday on the bailout news. Banco Bilbao Vizcaya Argentaria SA (NYSE ADR: BBVA) slipped 5.36% to $10.42 and Banco Santander, S.A. (NYSE ADR: STD) fell 5.19% to $10.41.

Goldman Sachs Group, Inc. (NYSE: GS) announced it was cautious on Spanish banks and Credit Suisse cut earnings per share estimates 2%-4% for the industry.

Analysts say investors have yet another reason to pull out of Europe and head for the United States.

"[T]he U.S. offers a better destination for capital than the EU at the moment," David Miller, head of alternatives at Cheviot Asset Management, told CNBC. "The growth dynamic in the U.S. is favorable and America also has a history of tackling big deficits. Europe, since the launch of the euro, does not."

News and Related Story Links:

• Bloomberg:
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• Investors Business Daily:
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• CNBC:
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These two issues continue to simmer and dampen confidence. The Federal Reserve is normalizing its policy by phasing out emergency lending facilities created in the wake of the 2008 credit crisis. The next big move will be the end of its direct purchases of mortgages within the next few weeks. Long-term interest rates will likely rise as a result.

Stocks can still rise in that environment, but much more tepidly and selectively than last year.

The Greek Tragedy

Meanwhile, across the Atlantic, policymakers and bank chiefs have been scrambling to structure a public-private bailout for high-debt, high-deficit Greece and prevent a further loss of confidence in the solidarity of the Eurozone. The fear is if Greece goes down and defaults on its debts, it will be closely followed by Spain, Portugal, Ireland, and even the United Kingdom, which are all interconnected and struggling under their own massive debts.

There are two ways the sovereign debt crisis can pull down economic growth.

The first is related to government spending, which has so far dampened the effects of the global recession. No matter what politicians in places like Greece do, they will need to tighten spending. Either they enact austerity measures over citizens' objections by raising taxes and cutting spending to please the bond market, or their borrowing costs skyrocket and they have to cut spending to divert funds to pay interest. 

The second concerns the banking sector. German banks own $520 billion worth of debt issued by the governments of Greece, Italy, Portugal, and Spain. French banks hold $73 billion worth of Greek debt. If such banks are forced to recognize losses on these assets in the case of default, it will be a repeat of the 2008 credit crisis - lending will cease, banks will need to be bailed out, and the economy will fall back into recession. 

Any major losses will trigger mark-to-market rules: Marked-down loans will cause the value of the collateral to erode; organizations would have to put up more collateral, which would require more asset sales at discounts, which leads to more mark-to-market losses.

Surely you remember this vicious cycle? It was only a year ago.

Spendthrift consumers and overzealous real estate investment caused the first crisis. The second - if it occurs - will be caused by spendthrift politicians and the zealotry of public employee unions fighting cuts to benefits and wages that are desperately needed to balance government finances. 

Greece sold $5 billion worth of bonds last week, but that was not the final test. In April, the country will need to roll over nearly $20 billion in debt so a solution will need to be found by then. The clock is ticking like a time bomb.

Now we have fresh worries about the health of the American consumer despite strong retail numbers. New data shows the turnaround in the job market has stalled while home prices look vulnerable to another slide. Mortgage applications for new purchases dropped to a 12-year low last week. While many Wall Street economists expected payrolls to be expanding by now, it seems that net job creation will be pushed back to April at the earliest. 

So where does this all leave us?

What's Next?

The sovereign debt issue has the greatest potential to scuttle the entire economic recovery. The other issues are of secondary concern. The Fed has indicated that it intends to keep short-term rates low for a long time. Businesses continue to invest, and with productivity gains at record levels, managers will soon have no other choice but to hire. And finally, the housing rebound has been adversely affected by bad weather. 

As for the sovereign debt troubles, like the 2007-2008 period, much depends on the outcome of political processes. My research, experience, and intuition suggest that Europe will find a solution, even if it's just a way to push the problem a little further out in time.

Greek leaders, despite huge and sometimes violent protests, are showing courage by proposing deep and painful measures to fix their country's finances. And while leaders in Germany and France will continue to put pressure on their weaker neighbors to ensure these hard choices are made, they are loath to do anything that would blow more holes in the balance sheets of their financial institutions. 

Greece's ability to float $5 billion worth of bonds that were oversubscribed by three-times has been hailed as a great breakthrough for its debt crisis. Although, three things must be noted:

First, at a certain yield almost any bond issue will sell well. Demand is not the issue - it's the price that's paid to court that demand. In order to help close its budget deficit to 8.7% this year from 12.7% of GDP last year, Greece set its coupon at 6.25%. That's a big premium over a German 20-year bond yield of 3.8% or British 20-year yield of 4.5%. Considering that there's a virtual EU guarantee on the bonds at this point, no wonder it was oversubscribed.

Second, you have to wonder if Greece can stand the pressures that lie ahead. The country has another 20 billion euros ($27 billion) worth of debt maturing over the next three months, and austerity measures have brought massive protests from Greek citizens. Even if the austerity measures go through, the effect they will have on the nation's economy - cutting public sector wages and buying far fewer Greek goods - will be difficult to weather.

Third, credit bears in the hedge fund community that bought one-year credit default swaps on Greek debt in recent days have seen their profits evaporate. These are not very liquid instruments, so they're a lot harder to sell than they are to buy. As hedge funds try to cover what are essentially Greek bond shorts, they will be squeezed heavily. Expect this to: A) boost the euro, which as you know by now has the effect of also goosing commodity prices; and B) cause the credit bears to sting quite a bit, potentially forcing them to retreat for a while if the world equity markets move higher against their positions.

Greece will likely fade from the headlines for a while from the perspective of the global stock markets. Germany and France will balk at helping out, but they are bound by honor, precedence, and law to muddle through to a solution. This may force credit bears to cover, which would be a positive. But expect the problems to come back, possibly in a bigger way, later in the summer.

As a result, I expect the issue to drag on for a few months before Europe's leaders establish a systematic solution to deal with fiscal troubles within the Eurozone. This is like the piecemeal fashion in which the U.S. government supported the financial system in 2007 and 2008 before the establishment of the Troubled Asset Relief Program (TARP) helped deal with the problem in a holistic way. Once a rescue apparatus was put in place, confidence returned and the stock market climbed. I expect a similar result here. 

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"Together they constitute too large of a portion of euroland to be helped in this way," Soros said. "The survival of Greece would still leave the future of the euro in question. Even if it handles the current crisis, what about the next one?"

This isn't the first time during the ongoing financial crisis that the situation was slated to worsen before it improved. Almost exactly one year ago, while speaking at a Columbia University dinner, Soros warned - correctly -- that the world financial system had effectively disintegrated, meaning the end of the economic misery was nowhere in sight.

In fact, Soros actually compared the financial crisis to the breakup of the Soviet Union, and said that the whipsaw effects of the crisis would prove to be more severe than the Great Depression.

"We witnessed the collapse of the financial system," Soros told the audience during his February 2009 speech. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom."

Soros cemented his reputation as an investing icon with The Quantum Fund, a hedge fund that's often described as the first real global investment fund, which he and Jim Rogers founded in 1970. Over the next decade, Quantum gained 4,200%, while the Standard & Poor's 500 Index climbed about 50%.

Gloom in Greece

Greece's deficit swelled to 12.7% of gross domestic product (GDP) in 2009, way above the European Union's 3% cap. Greece's government leaders have pledged to reduce that nation's budget deficit to 8.7% in 2010, but that goal won't be easily met.

Flights were grounded and schools shuttered across Greece yesterday (Wednesday), as civil servants and private-sector workers went on a nationwide strike to protest EU-backed austerity measures. Police employed tear gas to quell uprisings involving 15,000-25,000 protestors in Athens, The FT reported.

According to Soros, the rescue plan for Greece has a key weakness: The euro is fundamentally flawed because there is no Treasury agency backing it.

"When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a Treasury can deal with problems of solvency," he said. "This is a well-known fact that should have been clear to everyone involved in the creation of the euro."

For that reason a well-organized eurobond market is desirable - as are more-intrusive monitoring and institutional arrangements for conditional assistance, Soros said.

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• Wikipedia:
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"The downgrade reflects concerns over the medium-term outlook for public finances given the weak credibility of fiscal institutions and the policy framework in Greece, exacerbated by uncertainty over the prospects for a balanced and sustained economic recovery," said Fitch.

Greece has failed to contain its deficit, which this year is expected to total 12.7% of gross domestic product (GDP). The country's current account deficit rose to nearly 15% of GDP last year, but probably fell below 9% for 2009.

Meanwhile, the European Commission (EC) projects Greece's total government debt will exceed 112% of GDP. In downgrading the nation's credit, Fitch said government debt was likely to rise to close to 130% of GDP before stabilizing, and that proposed pension reforms, spending cuts and broadening of the tax base would likely not be strong enough to reduce its debt burden.

However, Greece is just one of the region's troubled economies. Europe's most vulnerable countries have been nicknamed the "PIGS," - Portugal, Ireland, Italy, Greece, and Spain.

Fitch has downgraded its outlook on Portugal's sovereign-credit rating to "negative" from "stable," as well, citing a deterioration of public finances.

However, Spain could be most at risk, Credit Suisse Group AG (NYSE: CS) analysts said in note to clients.

"To us domestic Spain looks most vulnerable," said Credit Suisse. "Productivity growth has been zero for 20 years, so Spain can't innovate its way out of the crisis."

The bank cited figures from the International Monetary Fund (IMF) that indicate Spain's housing sector it still 12% overvalued, and that with a house price to wage ratio of 6.2, is probably even more overvalued. At its peak, 20% of GDP was accounted for by the housing sector and construction.

"Spain is about 20% overleveraged, looking at private sector debt as a proportion of GDP versus GDP per capita. And its aggregate leverage (private and government) is higher than that of Greece," Credit Suisse said. "In our opinion, reducing Spain's sizable fiscal and economic imbalances requires strong policy actions which have not yet materialised."

Spain's budget deficit will be one of the widest in the euro-region this year at 11.2% of GDP, according to the EC.

S&P put Greece's debt on watch for a downgrade two days ago, following Fitch's downgrade. The ratings agency in March cut Ireland's triple-A sovereign debt rating by one notch and downgraded Portugal's rating in January.  

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