Spain is too big to fail but are Italian banks too big to save?

The latest round of gyrations in Europe’s credit markets have left the banks seen as most vulnerable to a massive default roughly where they were on Monday — which is to say, not in great shape.

Suspicions that the Spanish economy is weakening under the pressure of budget-driven austerity have weighed on the price of the country’s bonds and eroded their book value for the banks that hold them.

Traders are now trained to look for cross-border contagion, encouraging them to take out their frustrations on Italy — seen as the next weak link in the European chain — in advance of any fresh signs of concrete deterioration there.

As a result, the last few bond auctions in both countries have gone extraordinarily poorly as buyers simply fail to emerge for Spanish debt and force Italy to pay a significant risk premium before it can sell its bonds.

And the banks sitting on those bonds have been punished as well.

Since the first bad Spanish auction of this cycle, Banco Santander (STD, quote) is down 6.5%. Its Italian counterparts, Unicredit (UNCFF, quote) and Intesa (ISNPY, quote), are down a staggering 14% and 10%, respectively.

The theory here seems to be that Spain may be more likely to fail, but the European Union has the resources and the will to save it. But if Italy — the world’s third-largest credit market — goes under, no rescue package will make a difference.

In other words, Spain is too big to fail, but Italy is too big to save. In the worst case scenario, Unicredit in particular may be doomed.

At this point, UNCFF in particular is so badly battered that yesterday’s 6% rebound looks great from a one-day perspective. But when you consider that this company has lost 90% of its post-crash peak value over the last 2-1/2 years, 17 cents more or less is not going to repair the damage overnight.

ISNPY is in slightly better condition, but even a 65% decline is harrowing for one of Italy’s top financial institutions to heal.

Despite being exposed to Spain’s arguably weaker credit markets, STD is still trading above its credit-crash lows — unlike its Italian counterparts — and is down “only” 60% from its October 2009 peak.

French and German banks have also suffered, but not to the extent to which the Italian sector has been punished.

On the continent, only Greek banks like National Bank of Greece (NBG, quote) have fared worse — and the aggregate losses between NBG and UNCFF are only 2 percentage points apart.

Right now Spanish 10-year bond yields have tracked back up to 5.85% as the outlook on the European economy has soured. That puts us back where we were in early November, when it looked like the crisis might spread all the way to the banks of Paris — and right before the world’s central banks took extraordinary measures to soothe the markets.

On the other hand, the once-considerable spread between Italian and Spanish yields has narrowed. A 10-year Italian bond now carries an effective yield of 5.536%, barely 30 basis points below its Madrid-issued equivalent.

The good news is that Italian yields are still well below the “unsustainable” 7%-and-up levels we saw last October and November. 

The bad news may be that while yields have recovered somewhat, bank stocks have kept deteriorating.

This may be an opportunity. But who wants to catch the falling knife?