Core bank exposure to Italian debt an order of magnitude larger than periphery combined

Joe Weisenthal over at Business Insider put the following chart together:

As I said yesterday:

As financial markets increasingly turn to Italy, we should remember that Italy is the 3rd largest economy in the euro zone and it has deep connections throughout the euro area. This morning’s Handelsblatt says “if the country is in serious difficulties, the German banks have a problem.” And that is because Italy is among the largest debtors in the euro area of German financial institutions, with an estimated $116 billion of debt outstanding financed by German institutions.

A situation in which the Italians borrow for 5% or more for 10-year debt is unsustainable. Today Italy sold one-year paper with a gross yield of 3.67%, up from 2.15% at the last auction in June. What will the response be to this contagion to Europe’s core?

I will stick with my analysis from last November:

We are now seeing euro zone divergence as investors are becoming increasingly aware of the different risk profiles within the euro zone core. But even France and Austria have worsened here. Finland, Austria, France, Germany, and the Netherlands are probably the core of the less indebted nations (see More Charts on Debt in Europe, Germany and the Periphery). Could we see a union of these nations along with Luxembourg, Cyprus, Slovenia and Slovakia (and maybe Estonia) but leaving out two of the founding members of the EU? I doubt it seriously. So, either the euro zone dissolves entirely or it remains intact and creates more mechanisms that bind it together. I still think it will be the latter.

My view is that some combination of monetisation and default is the most likely scenario for Europe.

–Three options for the euro zone: monetisation, default, or break-up

Clearly, the Europeans’ dithering has had catastrophic consequences. The extend and pretend strategy has not prevented contagion from infecting the core. So we need to see a response here. In the shorter-term, the Europeans are likely to monetise i.e. buy up Italian debt and punish speculators. In fact, were the ECB to ‘guarantee’ Italian rates the way I have indicated the Fed might eventually do with QE3, so-called rate easing, the Italian liquidity problem would end immediately. However, there is understandably great resistance to this. I see a breakup scenario as increasingly probable down the line.

UPDATE 900ET: Apparently, the monetisation has already begun. Reports are that the ECB is buying up Spanish debt as we speak.