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Thanks a lot, Europe

August 5, 2011, 4:59 PM UTC

The massive selloff in U.S. markets on Thursday appears rooted in Europe as fears of a sovereign debt default in Italy and Spain caused traders to panic and run for cover. The markets had temporarily turned away from the crippling debt crisis in Europe two weeks ago as the debt ceiling debate in the U.S. took center stage. But with that issue ostensibly settled, traders turned their attention back to Europe – and they didn’t like what they saw.

The European Central Bank attempted to ease the market’s fears, but it seemed to have only exacerbated the problem. European leaders are now scrambling to avoid an all-out run on the euro as the European sovereign debt crisis enters a possible terminal phase. Spanish and Italian bond yields rallied slightly in European trading on Friday on the hopes that France and Germany will come up with some sort of solution to the current imbroglio. So far, neither side has come up with a solution. Whatever they do, they will need to act fast to restore market confidence or the current correction could turn to capitulation.

Scenes of the fall of 2008 were evident yesterday. And the sell-off was not just reserved for equities — oil and gold, which normally act as a storage of wealth, also fell as worried investors put all their money in cash. The market rebounded following a strong jobs report this morning.

All this cash is being dumped into custodial banks in the U.S. This led the Bank of New York Mellon (BK), the largest custodial bank, to start charging its institutional clients a fee for depositing what they consider an “extraordinarily high” amount of cash — it has no place to invest it either, and higher cash levels mean higher FDIC fees.

You know it’s bad when even the banks don’t want your money. So how did this all happen? The farcical debate on the debt ceiling temporarily distracted traders from the slow-motion sovereign debt crisis in Europe. There are stark differences between the debt dilemmas in the U.S. and Europe. In general, the current U.S. debt crisis is largely a self imposed one. Investors still want to buy U.S. debt. Conversely, in Europe, investors are hesitant to buy the debt of the peripheral nations of the eurozone, forcing bond yields to skyrocket. Yields on Italian and Spanish debt passed 6% this week, hitting a record differential to German government bonds.

In response, the European Central Bank announced on Thursday that it would restart a controversial program of buying up the sovereign debt of member nations. The move would ostensibly place the obligations of the peripheral euro member states on to its balance sheet. But this confidence building measure seems to have backfired. Investors fear that the ECB could be biting off way more than it can chew by initiating this second round of bond buying, leading to a false sense of security.

When intervention backfires

Direct ECB intervention in the bond markets last May was seen as troubling to some of the eurozone’s core members, especially Germany. That’s why EU leaders agreed last month to transfer this role to the European Financial Stability Facility (EFSF). This fund, which was set up last year by core euro members to support rescue packages in the eurozone periphery, would now be allowed to buy up the debt of member nations who were having a hard time finding willing buyers for their bonds.

But the EFSF still is not authorized to make any purchases — the plan must be approved by every euro member’s parliament. Furthermore, the EFSF doesn’t appear to have enough cash for the job. To maintain its triple-A credit rating, as the EFSF issues its own bonds to pay for all the bad debt it buys up, it could only really acquire around 300 billion euros worth of debt. That would have been sufficient to cover the short term funding needs of Greece, but it appears to be woefully inadequate to backstop the funding needs of Greece, Portugal and Ireland at the same time.

But around a month ago the contagion had spread to Italy and Spain, the eurozone’s third and fourth-largest economies, respectively. The EFSF couldn’t even make a dent in covering the debt requirements of these countries. Italy’s funding needs this year alone is projected to be 425 billion euros – nearly the entire EFSF. It has already raised around 277 billion euros, but still has around 150 billion euros left to raise. Spain has about 38 billion euros left to raise this year, bringing the total amount the two nations need to around 188 billion euros.

The ECB’s move to bypass the EFSF and buy up troubled sovereign debt signaled to many traders in the City of London and Wall Street that panic was setting in on the streets of Frankfurt, the home of the ECB. The ECB was seen buying up only Irish and Portuguese bonds yesterday, but traders tell Fortune that they were looking into buying large blocks of Italian and Spanish debt in the coming days. Italian and Spanish bonds have much of their debt maturing in the next five to 10 years, so they will need large amounts of cash from the ECB to stay afloat if they aren’t able to raise funds in the open markets at reasonable interest rates.

Nevertheless, the market signaled on Thursday that it had no faith in the ECB’s new role of being this sort of lender of last resort to its member nations. After all, the Italian debt market alone is around 1.8 trillion euros. Not even the ECB could wrap its arms around that one – yet alone wrap its arms around all the other PIIGS nations at the same time. To make matters worse, cracks are beginning to form in some of the so-called core eurozone members. Yields on French and Belgian sovereign bonds started to climb into dangerous territory yesterday and could continue on their way up.

Unlike with the U.S., the European debt contagion appears to be a fast moving disease, which is picking up steam. Investors are trying to position themselves as far away from the contagion as possible, opting to liquidate equities, bonds and commodities into plain old cash. The situation is somewhat analogous to a bank run on the sovereign bonds of these countries, with the ECB acting as the FDIC. But even as hefty as the FDIC is today, it doesn’t have enough cash to bailout every single bank in the U.S.

The reason the U.S. banking system stays afloat is because people believe in the system. Therefore, if the eurozone periphery is to be saved, investors need to believe in the ECB and its leadership. If confidence doesn’t return, the European contagion could quickly spread to all major markets.