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By John Nyaradi

Spain and Italy walk closer to the edge as Greek elections loom in background. Spain's continuing financial crisis involving its banks has been a major concern to the global economy for the past 2.5 years. Europe (VGK) thought it had finally found a solution that would calm the markets for a time, as many European partners were willing to help stabilize Spain's banking system by offering 100 billion euros ($125 billion). Unfortunately, after the markets were initially satisfied with this arrangement, fear started to creep back into the marketplace once the fine details of the bailout were examined.

There are two main concerns regarding this bailout:

  1. The concern over whether Spain's (EWP) public debt will increase that much more due to the emergency loans it will receive to recapitalize its banks or not.

  2. The concern over whether Madrid's official creditors - the European countries that are offering the 100 billion euro (FXE) loan - will get priority in being repaid first before private creditors of Spanish debt are repaid or not.

Combine those two concerns with the fact that 18 Spanish banks had their credit ratings downgraded, and the end result is that the interest rate on 10-year Spanish bonds rose to 6.8% Tuesday, the highest it has been since the eurozone was established. Additionally, the 6.8% rate is dangerously close to the 7.0% rate that Ireland, Portugal, and Greece reached, resulting in all three countries having to accept international bailouts to keep their countries from defaulting on their debts.

The big difference, and a major problem for Europe, is that this bailout is just for the Spanish banks, not for the Spanish government as was the case with those three aforementioned countries. While Europe likely has the resources to save the Spanish banks, it likely does not have the resources to save the Spanish government if it would need a bailout, and that possibility is becoming more likely as the Spanish banks continue to remain in turmoil.

While Europe was hoping that the markets would see the validity of the approach that Europe is taking to save Spain (EWP) from the debt it has incurred due to the real estate bubble burst, investors are unconvinced that this bailout is anything more than a temporary band-aid rather than a permanent solution.

What is also concerning to investors is the timing. On Sunday, June 17, Greece will hold an election to decide which party will take control of Greece's Parliament after an effort to unite the parties failed in May. There is a strong chance that the hard-left Syriza party will win more seats in the Greek Parliament than any of the other parties. This is significant because Syriza has vowed to break the bailout terms that Greece agreed to last month. If Syriza does take control of the Parliament and carries out its promise to break the bailout terms, it could lead to Greece leaving the eurozone, which could have dire repercussions for Europe, and consequently, the global economy as a whole.

These dire repercussions could include investors becoming very leery of having investments in equally shaky, but larger, economies such as Spain and Italy (EWI). While Greece has the 32nd-largest economy in the world, Spain has the 5th-largest economy in the eurozone and 12th-largest economy in the world, while Italy has the 3rd-largest economy in the eurozone and 7th-largest economy in the world. If there is an en masse exit from such investments, the future of the euro currency across Europe could very well be in doubt.

While there is a chance that the parties that favor Greece's bailout agreement with the European Central Bank (ECB) will win out, even this will not be a total victory, as it's likely that those parties will want to have some of the bailout terms renegotiated, thereby negating the effectiveness of the bailout package. This is due to the fact that many Greeks are unhappy with the deep austerity cuts that the bailout package is demanding, leading to massive rises in homelessness, hunger, unemployment, and even suicide.

One developing problem with Greece's troublesome economy is the fact that Cyprus, Greece's close island neighbor, has a large exposure to Greek debt. It is possible that the Cypriot government could request a financial bailout within a few weeks' time, adding a fifth eurozone nation to seek help from its European partners, further deteriorating Europe's already unsettled financial landscape. Europe would likely be able to bail out the Cypriot government, since it is a much smaller economy than even Greece's, but it would still send financial and political shockwaves throughout Europe that would likely reverberate throughout the global economy and lengthen the potential recession that is setting up throughout much of the world.

The other main concern in the eurozone is Italy (EWI). Italy's 10-year bond yield had risen to as high as 6.26%, the highest it has been in 2012 to this point. It finished the day at 6.13%. The growing Italian yield comes ahead of a crucial bond auction on Thursday, June 14. Investors are becoming increasingly concerned that the Italian government will also need a bailout. This is especially concerning because Italy is the eurozone's 3rd-largest economy.

If the Spanish government needs a bailout after its banks have been offered a bailout, there would be virtually nothing left for Europe to offer aid to any other country that needed a bailout, and especially an economy as large as Italy's. Further fears of contagion from Spain to Italy were increased after Austrian (EWO) Finance Minister Maria Fekter said in a television interview on Monday that the increasing Italian costs of borrowing could lead to a rescue. While she backtracked from those comments on Tuesday, the damage likely was already done as far as investors are concerned.

Italy, meanwhile, is facing a large 1.9 trillion euro public debt. This debt is likely to increase due to the fact that the austerity measures imposed by Italian Prime Minister Mario Monti are crippling Italy's growth and cutting back on Italians' consumption of goods. Currently, Italy has Europe's 2nd-highest debt-to-GDP ratio. Furthermore, the Italian government is having difficulty finding the public funds needed to enact measures to stimulate its economy, thereby increasing the chances that an Italian bailout will be needed in the future.

The question is if Italy will actually need a bailout or not. According to Sean Egan, the Founding Partner and President of Egan-Jones, an independent ratings agency, the chances of both Spain and Italy requesting help from the European Union within the next six months is quite high due to the fact that both countries have high levels of government debt and both countries have banks with poor credit qualities. Poor government and bank credit quality usually go hand-in-hand, thereby indicating that the governments of Spain and Italy are in as much financial trouble as their banking systems are. This is why Egan believes it is likely that both governments will need to be bailed out within the next six months.

Executive Summary:

There is still much financial and political strife in Europe. Spain's increasing 10-year bond yields are not only indicating that Spain's banking sector needs a financial bailout after all of the bad debt it accumulated during the housing crisis, but the Spanish government itself may need a bailout.

This comes at a very inopportune time for Europe as it braces for Greece's elections this Sunday, June 17. It is expected that Greece's hard-left Syriza party, which has vowed to break the financial bailout agreed upon by Greece and the ECB, will win the most seats in Greece's Parliament. This could potentially lead to Greece exiting the eurozone, thereby creating more havoc and chaos for Europe. Add to this the fact that Italy's economy is struggling with mounting public debt and an increasing 10-year bond yield, and some experts are believing that the Italian government will request a bailout package of its own, possibly within the next 6 months.

Bottom Line:

All of the aforementioned news could potentially lead to Europe remaining in a lengthy recession, which could potentially drag down the global economy as a whole, including the markets of the United States (SPY), China (FXI), and elsewhere, for some time to come.

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.

Source: European Crisis Update: VGK, FXE. EWP, EWI, EWO, FXI, SPY