Why Madrid’s shell game backfired

July 24, 2012, 6:34 PM UTC

FORTUNE — It looks like the bond markets are done cutting Spain financial slack. Bond yields for Spanish sovereign debt broke well past the critical 7% mark Monday, hitting as high as 7.57%, on concerns that the government in Madrid will soon need a big sovereign bailout, thought to be around 300 billion euros. European and US stock markets fell on the news, with the S&P down 2.5% on the day.

This all comes days after eurozone leaders approved a 100 billion euro bailout of Spain’s crippled banking sector. But instead of things getting better, they have clearly just gotten worse.

In a bitter twist of irony, it seems that the bank bailout may have actually hastened the need for a possible full sovereign bailout as it has crushed investor demand for any kind of Spanish debt. This not only affected the sovereign but has also locked the nation’s 17 states or “regions” out of the bond market as well, forcing them to look to Madrid for a bailout of their own. If Spain doesn’t receive a comprehensive and fair bailout from its eurozone partners soon, the euro could very well end here.

It was only a matter of time before the markets caught on to Madrid’s shell game. In its 100 billion euro bank bailout, the Spanish government essentially socialized bank losses by simply transferring those losses from the banks to the government’s balance sheet. If that wasn’t bad enough, it also forced the banks’ subordinated bondholders to take a hit on the value of their investment, but allowed the senior debt holders to walk away with full value.

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In a corporate bankruptcy, it is true that equity holders and subordinated debt holders are at the bottom of the payout heap. But this is different. The subordinated bondholders in the nation’s banks were mostly (around two-thirds) made up of small-time investors who bought that debt thinking it was safe, often on the advice of their personal financial advisors. With the Spanish stock market down by a third this year, the Spanish investor has really taken a hit. This comes on top of the nation’s depression-like 25% unemployment rate.

But in pushing the losses on the little guy, the Spanish government basically shot itself in the foot. That’s because the local and regional bond markets in Spain are largely supported by local investors. After getting burned by the national government in the bank bailout, Spanish investors have understandably shunned government debt. With international investors and big pension funds out of the Spanish market for nearly a year, there is really no one left to buy up all that local Spanish debt.

Spain has tried to calm the situation with its regions by creating its own 18-billion euro bailout mechanism. But those 18 billion euros will be financed by selling more sovereign debt, which, at 7.57% would be prohibitively expensive.

That is partly why the market anticipates Spain will soon need a full on bailout from the EU. The national government is now responsible for covering the debts of its regions, as well as its own. It turns out that Spain’s official debt-to-GDP ratio didn’t give an accurate picture of the country’s sovereign risk. That’s because it didn’t take into account the billions of euros of off-balance sheet items from its regions. Since those debts were implicitly backed by the national government, the market now believes that Madrid will need to take over the payments. Add in those off-balance sheet items and the nation’s debt-to-GDP ratio jumps from 68.5% to 87%, according to the Bank of Spain. Top it off with the 100 billion euros bank bailout and the ratio jumps to around 96%.

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The national government cannot afford to finance its own debt at 7.57% for very long, let alone support its 17 regions as well. It already has the European Central Bank buying its debt to keep rates low but they are still too high. Traders in European debt tell Fortune that they believe the ECB will try to calm the melee by instituting another round of quantitative easing, which is known as LTRO in Europe, but which is still essentially just a fancy way of saying: “printing more money.”  The hope is that all this extra money in the system will boost investment and lending, lowering bond yields and taking the pressure off the national government.

But there is a limit to what the ECB can do here. It simply cannot finance Spain’s debt forever, just as Madrid cannot finance the debt of its regions forever. If Spain is unable to reopen its bond markets to private investors quickly, then it will soon be facing default.

The bond markets are clearly looking for a real long term solution to the euro question, but eurozone leaders are slow in getting there. In the meantime, a large and powerful sovereign bailout of Spain would help stabilize the markets – at least in the short term. Such a bailout would essentially exhaust what’s left of the European bailout fund, forcing eurozone members to either put up more money, which probably won’t happen, or to finally work to form a closer and more stable union. Either way, it appears as if the euro stops here with Spain.