Man-oh-man has the chatter shifted from the EU leaders. (Although Merkel keeps showing her solidarity, and offers a greater sacrifice from Germany.) The demand for the EFSF bonds are weak, and the spreads (against Germany) are rising. Europe acted too slow after amending the EFSF, and now the market sees it as a farce. So the fund that was suppose to re-capitalize banks or facilitate sovereign bond purchases, a key instrument to provide stability, has failed before it stated.
I think a few scenarios can play out:
1. The ECB gets amended, and acts as last resort lender. (They are already doing this for the sovereigns, but once they pull from the markets, rates just spike back up. There purchases are turning out to not be sustainable.)
2. Joint ECB/Feb Reserve response. (This would be tricky, politically. But for the sake of stabilization it may happen. If this does happen, I am sure the US will demand some sort of pain on the equity side from EU banks, as they did when facilitating US banks.)
The problem with 1 and 2 is that there is no mechanism to stabilize the EU banks. (Remember, Lehman had access to short-term funding, but still had a run.) In August/Sept, EU banks saw a very real run on their banks. With out the EFSF, it is only a matter of time before that run takes place again.
Bank runs will either force
1. a credit event
2. force merges and capitalization (but with out cash for the capitalization the next option is...)
3. the banks will get nationalized.
If the banks get nationalized, a wave of sovereign debt downgrades are coming.
All options will lead to a shock to the market. #1 causing the most severe damage, obviously.
A stability fund is desperately needed, now. Without it, the only play is pain.
If nationalization does not appeal to the EU countries and decide to allow countries to exit the EU (if only temporarily), some of the American banks maybe really fucked. US banks sold $5T (yes, trillion) in EU sovereign CDS protection. (WTF are they thinking?!?) So if Europe does blow up, or allows for exits, sovereign countries will default and the US banks are on the hook. Which means US banks blow up, and the Fed will have to intervene.
Even though the EU countries are now getting their houses in order, without a stability mechanism, things are not looking good. Europe needs a stability mechanism.