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The significance of Monday's sell-off should not be understated. What was supposed to be a relief rally in celebration of the Spanish bank bailout started to turn ugly midday as U.S. investors began to digest what European bond markets were telling them: far from signaling a turning point in the debt crisis, the $125 billion bailout of Spain's financial sector may actually exacerbate the eurozone's problems. The main concern: if drawn down in full, the bailout will add 10 percentage points to Spain's debt-to-GDP ratio which is already expected to hit 80% by the end of the year--this means Spain's debt-to-GDP will approach 90%, the level at which economists Rogoff and Reinhart found economic growth begins to contract. With Spanish real GDP already expected to fall around 2% in 2012 and another .5% in 2013 (according to Fitch), the country can ill-afford for economic activity to falter further.

Additionally, Nobel Prize winning economist Joseph Stiglitz dubbed the whole endeavor 'voodoo economics', noting that Spain will ultimately end up relying on the very same institutions it is bailing out to bail it out when the cost of the bank recapitalization hits investor confidence, making it more difficult for the country to borrow. In other words, Spain's borrowing costs are likely to rise further as the cost of the bailout negatively affects it's debt-to-GDP ratio, and with demand for its sovereign debt diminishing, the country will be forced to ask its banks (the very same banks it just bailed-out) to purchase the debt. In short, the government and the banks are propping each other up. This of course, has been going on for some time now and the new bailout seems to reinforce the nefarious practice rather than curtail it.

Complicating matters in the EU further, Ireland is now demanding the terms of its 2010 85 billion euro rescue deal be negotiated to more closely approximate those enjoyed by Spain--the bailout of Ireland came with a set of tough austerity measures attached to it, while the 'Spailout' came with no further EU/IMF demands for economic reforms. From The New Statesman:

...Ireland is getting fidgety as well. Its bailout - way back in November 2010 - happened for much the same reason as Spain's. An overextended banking sector exposed the whole country to risk which it had to ask for help for, but the government was, overall, fiscally responsible. Yet because it needed European funds before the EFSF had any powers narrower than a full-scale bailout, the money came with onerous terms which have not been matched in Spain's case. So Ireland may now be feeling hard done by...

This opens the door for Greece to seek a renegotiation of the terms of its own bailout and gives the anti-austerity Syriza party even more ammunition going into Sunday's critical (re)election.

In addition to inflaming tensions between Spain and countries whose bailout terms were far more harsh, the condition-free Spanish financial sector bailout sets the stage for other struggling countries to demand that the terms of any future bailouts be sterilized of any conditions that could be construed as punitive, adding fuel to the anti-austerity fire which, thanks to the ascendancy of Francois Hollande in France, is already burning bright. For example, Italy might very reasonably ask why its banks should not receive assistance. 'Austerity' and 'fiscal restraint' are now truly the most unpopular terms in all of Europe; so unpopular in fact, that it appears bailouts will now be given free of demands just to avoid the attendant unpleasantries.
All of this hit Spanish and Italian bonds hard Monday as the yield on the 10-year Spanish note rose a staggering 30 basis points during the session (and incredibly moved 60bps from low yield to high) while the yield on comparable Italian notes surged 26 basis points and climbed above 6% for the first time since early in the year. The spread between Spanish and German bonds widened substantially, and Spanish 5 year CDS blew above 600 basis points. One reason for the poor performance of Spanish bonds is bondholders' fear of 'subordination' wherein if the money for Spain's bailout comes from the European Stability Mechanism rather than the European Financial Stability Facility, bondholders' claims will be subordinate to the EU's. Countering the subordination fear however is

chatter...that loans to Spain could come from the EFSF in order to avoid the ESM's preferred creditor status, an EU official told Reuters, who added, "bailout could be transferred to ESM but loans already extended would not become senior to other debt." However, lack of clarity has proved insufficient to lift risky trades.

On the equity side, European shares, (which began the day with a strong rally) gave back all of their gains and then some by the end of the session, with Spanish stocks opening up nearly 6% before closing in the red and Italian shares opening up almost 4% before closing down by 2.75%. Notably, Spanish banks gave back all of their gains by the closing bell. Similarly, Wall Street opened higher before closing the day down nearly 1.5%.

Make no mistake, Monday could not have gone much worse considering the developments that occurred over the weekend. Monday's action proves that investors have lost confidence in Europe's ability to deal effectively with the crisis. Spain's borrowing costs simply cannot rise much further--the country has already said it is essentially shut-out of the market. Another 50 basis points (which, as I noted earlier, was the range for today) and the country's problems will grow exponentially.

Additionally, the Spanish bailout has set a dangerous precedent. Now, all European bailouts will be measured against the Spanish banking sector bailout in terms of the leniency of the conditions attached to the funds being 'awarded'. This means painful renegotiations of past bailouts and more 'conditionless' giveaways in the future, which will do nothing to solve Europe's problems. As mentioned above, the 'Spailout' will also embolden the anti-austerity party in Greece at a time when the market desperately needs the Greek bailout (and its terms) to remain intact. When a market that is addicted to stimulus, bailouts, and easy money no longer responds favorably to a $125 billion giveaway, one wonders what is left to boost equities and settle nervous investors. Short S&P 500 (NYSEARCA:SPY), long volatility (VIX) until there is greater clarity regarding the ramifications of the Spanish banking sector bailout and until the Greek election results are in.

Source: Why Monday's Sell-Off Was Even Worse Than It Seemed