From the 2012 Predictions Ticker:

The fissures -- if not outright failure -- in the Euro Zone become realized.  I fully expect one or more nations to leave the Euro and there is a non-zero chance of an outright collapse.  Timing is the problem -- I'll go ahead and stick this in 2012 but may be early a year.  We'll see.  Incidentally because of how I worded this Greece leaving is a "score" but I'm not thinking Greece here -- try Spain or Italy on for size.

And now we have this:

Spain’s surging bad loans are spurring doubt on whether the government can persuade investors that it can clean up the country’s banks without further damaging public finances.

Non-performing loans as a proportion of total lending jumped to 8.16 percent in February, the highest level since 1994, from less than 1 percent in 2007, according to Bank of Spain data published today. The ratio rose from 7.91 percent in January as 3.8 billion euros of loans soured in February, a 110 percent increase from the same month a year ago. That takes the total credit in the economy that the regulator lists as“doubtful” to 143.8 billion euros.

This is bad.  Very bad, when one considers that Western Banking Systems all depend on default rates closer to 1%, not 8%.

Why?  Because of leverage.  If you're running 30:1 gearing then a 3.3% loss wipes you out.  A 1% loss is tolerable, but just barely. 

And all western "banking systems" have been run between 10:1 and more than 30:1 for the last couple of decades, with Europe consistently at or above the top end of that scale.

It's not just private funding either; worse is the government side:

Spanish, Italian and Portuguese banks are loading up on bonds issued by their own governments, a move that shifts more of the risk of sovereign default to European taxpayers from private creditors.

Holdings of Spanish government debt by lenders based in the country jumped 26 percent in two months, to 220 billion euros ($289 billion) at the end of January, data from Spain’s treasuryshow. Italian banks increased ownership of their nation’s sovereign bonds by 31 percent to 267 billion euros in the three months ended in February, according to Bank of Italy data.

This is picking up shiny pennies in front of a steamroller.  The banks are doing this because they can borrow from the ECB at 1% and then "buy" Spanish 10 year debt at 6%.

What could possibly go wrong with this, especially when you can count the sovereign debt as all "money good" and thus factor it via a repo and do it again, and again, and again.

That is, it's not a 5% profit being sought, it's a 50% profit -- by engaging in 10 "turns" of this crank. 

Let's illustrate the problem with this "theory."

You start with €1 billion in capital.  You buy €1 billion in Spanish bonds.  On these you expect to earn a 5% profit, because you paid 1% interest but will receive 6%.  That is, you will get €50 million in net profit on this transaction.

But that's not enough.  So you pledge the bonds you own into a repo transaction (say, with the ECB) and use that to borrow another €1 billion, with which you do it again.

And again.

And again.

Soon you have €10 billion in bonds.  And you have €500 million in annual interest profits!

That's damn good on €1 billion in capital -- it's a return of 50% annually on your "investment."

But what happens if you suffer just a 1.5% loss on the capital value of those bonds?

You got a problem don't you?  You lose €150 million which is 15% of your capital.  You say "oh but the interest is still ok" and it initially is, except that the impairment will eventually result in a margin call.  Now what happens?  More selling shows up.  And when the decline in the capital value reaches 10%?  Oh gee, there's a billion euro hole which just happens to equal your capital, and now you're broke.

This is the problem facing Europe.  The entire system is levered like this and now, in a desperate attempt to keep the game going the banks are "eating their own tails" by buying up sovereign debt with loans from the ECB.  This is a desperate attempt to cover the losses on their property lending and yet all it winds up being is a sop to the governments which are deficit spending like mad to "prop up" their consumption.

This is a mathematical impossibility and everyone knows it, but the market is sticking its fingers in its ears and doing the "la la la la la la" game.

For now.