Italy: Europe’s Fannie Mae moment? by Colin Barr @FortuneMagazine July 11, 2011, 3:15 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons After a long simmer, Europe’s debt crisis is coming to a boil. The market has turned against the Continent with a vengeance. European bank stocks sold off for the second straight day, while the euro sank against both the dollar (see chart, right) and the Swiss franc. Peering over the cliff? The euro hit $1.41, down a nickel from its recent high just ahead of the July 4 holiday here. Big European financial companies, ranging from Deutsche Bank db of Germany and Barclays bcs of the U.K. to Unicredit of Italy, saw their shares drop 6%-8%. The selloff started last week with a flight from government bonds issued by weaker European states. Italian and Spanish government bonds are trading at more than double the interest rates being paid on German government debt — the highest spreads since the euro started trading a dozen years ago. The plunge of weaker-country government bond prices raises new fears about the health of European banks, which are big holders of sovereign debt. The selloff comes just ahead of the release of the results of the latest round of European bank stress tests. While European policymakers are hoping that the tests will ease fears about the health of the banking system, the plunge of Italian government bond prices in recent days throws a new wrench into that plan. Only a month ago Italy looked financially stretched but probably safe, as investors focused on whether Spain could survive an expected market test. Italy has a famously dysfunctional government and a big debt load, which is obviously problematic in a world of slow growth and overextended banks. Yet it has been running a small primary budget surplus, meaning government revenue exceeds spending excluding interest payments – a key measure of whether belt tightening can help cure fiscal ills. But that brand of wishful thinking seems to have gone out of style last month, when a downgrade of Italy’s debt-rating outlook signaled that the weaker European states will no longer get the benefit of the doubt. As Moody’s said at the time: The continued stability of market demand for Italy’s debt is uncertain at current yields. Although future policy actions within the euro area could reduce investors’ concerns and stabilize funding costs, the opposite is also possible. In any event, going forward, investors appear likely to differentiate more among euro area sovereign borrowers than they did prior to the financial crisis, to the disadvantage of euro area countries with higher-than-average debt burdens, like Italy. European policymakers are meeting again this week, and there are signs they are getting their heads around the size of the crisis. They are now discussing moves that would cut Greece’s debt burden rather than simply lengthening the payback period, which is a welcome shift. The will have to be many bondholder haircuts all over the world before this crisis finally ends. At the same time, it is hard to escape the feeling that the market’s turning on Italy is like the run on Fannie Mae in the early summer of 2008 – the moment at which it becomes clear that the scope of the crisis won’t allow any easy escape. If the market keeps shunning Italian and Spanish debt and bank stocks keep falling, Europe will face more damaging bank runs and a disorderly default on someone’s debt will become almost unavoidable. The endgame may not come quite as quickly this time round, for which we can be glad. But no matter what Europe’s leaders do, it seems clear that there is going to be no shortage of pain for everyone to share.