A funny thing happened in Euro spreads today. While the bonds of all PIIGS countries surged higher in price (and plunged in yield) upon the announcement of the second Big Bang bailout, the reaction in core Eurozone credit was hardly as exuberant, and in fact spreads of the two core European countries pushed wider by the end of the day, and over the last week. Why? After all the elimination of peripheral risk should have been seen as favorable for everyone involved, most certainly for those who had been seen as supporting the ever more rickety house of European cards. Well, no. Basically what happened today was a two part deal: the i) funding of future debt for countries that are currently locked out of the market (all the PIIGS and possibly core countries soon) or in other words the "liquidity mechanism" which is being satisfied by the EFSF "TARP-like" expansion, and ii) the roll-over mechanism for existing holders of debt which "allows" them to "voluntarily" transfer existing obligations into a "fresh start" Greece which can then emerge promptly from the Selective Default state that is coming from Moody's and S&P any second, and supposedly allow the country to access markets as a non-bankrupt country.

For all intents and purposes the second can be ignored, because as has been made clear over the past few days, and as will be demonstrated below, the actual rollover from non-Peripheral banks will be de minimis, the bulk of impaired debt being held by banks in the host countries as is, and used as collateral with the ECB in the form of par instruments for cash.

Now the second part of the mechanism was never an issue further demonstrated by the plunge in net notional in Greek CDS as core banks no longer needed to hedge exposure and instead opted to divest their holdings. This is merely a red herring that attempts to confuse the issues associated with the first, and far more important concept: the nuances of the EFSF and its imminent expansion. And expand it will have to, because in reality what is happening is that the net debt of the countries will end up growing even more over time for one simple reason: this is not a restructuring of existing debt from the perspective of the host country! Simply said Greek debt will continue growing as a percentage of its GDP, meaning it, and Ireland, and Portugal, and soon thereafter Italy and Spain will be forced to borrow exclusively from the EFSF. Therein lies the rub. In a just released report by Bernstein, which has actually done the math on the required contributions to the EFSF by the core countries, the bottom line is that for an enlarged EFSF (which is what its blank check expansion today provided) to be effective, it will need to cover Italy and Belgium. As AB says, "its firepower would have to rise to €1.45trn backed by a total of €1.7trn guarantees." And here is where the whole premise breaks down, if not from a financial standpoint, then certainly from a political one: "As the guarantees of the periphery including Italy are worthless, the Guarantee Germany would have to provide rises to €790bn or 32% of GDP." That's right: by not monetizing European debt on its books, the ECB has effectively left Germany holding the bag to the entire European bailout via the blank check SPV. The cost if things go wrong: a third of the country economic output, and the worst case scenario: a depression the likes of which Germany has not seen since the 1920-30s. Oh, and if France gets downgraded, Germany's pro rata share of funding the EFSF jumps to a mindboggling €1.385 trillion, or 56% of German GDP!

The Europarliament, ECB and IMF may have won their Pyrrhic victory today... But what happens tomorrow when every German (in a population of 82 very efficient million) wakes up to newspaper headlines screaming that their country is now on the hook to 32% of its GDP in order to keep insolvent Greece, with its 50-some year old retirement age, not to mention Ireland, Portugal, and soon Italy and Spain, as part of the Eurozone? What happens when these same 82 million realize that they are on the hook to sacrificing hundreds of years of welfare state entitlements (recall that Otto von Bismark was the original welfare state progentior) just so a few peripheral national can continue to lie about their deficits (the 6 month Greek deficit already is missing Its full year benchmark target by about 20%) and enjoy generous socialist benefits up to an including guaranteed pensions? What happens when an already mortally wounded in the polls Angela Merkel finds herself in the next general election and experiences an epic electoral loss? We will find out very, very shortly.

Here is Bernstein with the full breakdown:

Continuation of the current strategy with a materially enlarged EFSF and private sector participation in liquidity support

Despite the failure of the current strategy, there is still a theoretical option of an extension of the current liquidity support with a materially enlarged EFSF that would also be buying government bonds in the secondary market. We believe this is the least likely option given the size of the fund required to achieve the objective.

An extension of the EFSF to cover Italy and Spain would require a €790bn (32% of GDP) guarantee from Germany

This strategy is not only unlikely to succeed but would also run into some serious structural difficulties. To cover 100% of the roll-over for Greece, Portugal, Ireland, Spain, Italy and Belgium as well as an allowance for bank support at 7% of the banks' balance sheets until the end of 2013, the support mechanism(s), would need to be able to deploy a total of €2.4trn in available funds.

Assuming the Greek Loan facility and the EFSM remain in place, the EFSF would have to increase its deployable funds from currently about ~€270bn to €1,450bn.

Given the 20% overcollateralization requirement on the current EFSF structure and the fact that countries that receive EFSF support are not able to provide valid guarantees mean that in order to create a €1.45trn funding capacity, the total fund would have to be €1.7trn. The guarantees to be provided by Germany would have to be €791bn or 32% of GDP.

There is a legitimate question whether in particular Germany would see the point of committing that kind of support to a concept that has so far been extremely unsuccessful. It also would expose Germany to a worst case scenario of a French downgrade. Without France, the guarantee need would rapidly move towards the whole of the €1.7trn. As the market is getting increasingly concerned about France, the odds are heavily stacked against an extension of the EFSF as a pure liquidity support mechanism.

If Banks were to participate in a liquidity expansion their contribution would be minimal

Within the current strategy one of the open questions is whether or not the private sector can participate by providing liquidity to the periphery countries. We believe this to be a fundamentally marginal discussion despite its enormous political importance.

Based on the stress test data released on Friday, we find that whilst the banks account for the majority of the very short term paper, their total share of the funding requirement into 2013 is just 23% and 16% of the total EFSF.

The question is how big the private sector participation could be. Taking the "French proposal" as a guide, the private sector participation would reduce the size of the EFSF by €137bn or 9% of the €1.45bn EFSF funding, assuming 70% of the debt is rolled over, 30% collateralization and 75% of banks participate.

The problem with this private sector participation so far has been the risk that this may be regarded as a default by the rating agencies. As a consequence the banks would have to write down these exposures to market prices. This exercise would lead to reported write-downs for the European banking sector of €75bn, 0.55 times more than the liquidity support that the EU is seeking. And in particular in Portugal and Greece the fallout of the MTM losses far outstrips the increase in liquidity.

Even more importantly, more than half of these losses would occur in the banks of the periphery countries themselves. In the absence of an open market for these banks, the losses would have to be made up by the governments themselves and subsequently added back to the EFSF utilization.

And there you have it: the cost of the euro not plunging today as a result of the ECB not proceeding with outright monetization, is that Germany is now the ultimate backstopper of all of Europe's risk. And while before, when the EFSF was just over €400 billion or so, the market could largely ignore the risk, a €1.5 trillion "upgrade" certainly changes the equilibria dynamics. In an attempt to avoid the appearance of inviting inflationary pressures on Trichet's central bank, Germany has directly onboarded the risk associated with terminal failure of this latest and riskiest "bailout" plan and in doing so may have jeopardized anywhere between 32% and 56% of its entire annual economic output. One wonders if the risk of runaway inflation is worth offsetting the risk of a plunge into the worst depression in the nation's history? It sure isn't for the Fed.

The most ironic outcome would be if the eurozone, in an attempt to prevent further contagion at the periphery, simply invited the vigilantes to bypass Italy (recall how everyone was shocked that instead of attacking Spain, it was Italian spreads that got destroyed in a manner of days), and head straight for the country on whose shoulders lies the fate of the entire EUR experiment?

Is Atlas about to shrug and topple the entire oh so heavy house of cards?