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Portugal’s problems are bad, but they don’t have to rain bad news down on Spain.

Portugal’s prime minister resigned after his latest austerity plan was voted down, pushing the Continent’s simmering debt crisis to the front burner. A downgrade of Spanish banks – which have more than $100 billion of exposure to Portugal – added a pungent whiff of financial contagion.

This may pinch a little

The yield on Portuguese 10-year bonds surged near 8%. That makes it a matter of time till a new government asks for a bailout that could cost as much as $140 billion — and this just to stay upright so it can tighten its belt well beyond the pain point.

“Far-reaching structural reforms are needed,” Deutsche Bank economist Gilles Moec wrote Thursday. “No ‘adjustment-like’ approach would suffice.”

All this sounds depressingly like a replay of last spring’s Greek situation, which sent stock markets into free fall and threatened to derail the global recovery.

But this time, a market meltdown may not be in the cards. The euro, for instance, held above $1.40 in spite of the latest rumbles, and stock markets held their ground. Yields on Spanish bonds actually fell. 

For that you can credit the hawkishness of the European Central Bank and the liquid generosity of the Fed, among other things. But the muted reaction also suggests the Europeans have done more to defuse the sovereign debt time bomb than we have given them credit for.

“Believe it or not, we have come a long way,” said Jacob Funk Kirkegaard, a research fellow at the Peterson Institute for International Economics. “Last year we had people talking about the euro at parity and the euro zone breaking up. But now we can see there is a playbook to muddle through the next three or four years.”

It is a playbook that is still missing a few pages, to be sure.

European ministers have made progress in arranging for and funding bailout plans such as the European financial stability facility and its successor, the European stability mechanism. These vehicles ensure that troubled borrowers such as Portugal will be able to get funding in a crunch – at a price. The European summit today and Friday aims to lock in details on how those programs will be funded, among other things.

But Portugal isn’t likely to tap the bailout funds for another few months, till a new government is in place. That could put pressure on the European Central Bank to prop the country up during its lame duck period, by buying bonds in the secondary market. Portugal could need 15 billion euros of funding between now and June just to fund its deficit and scheduled bond payments, Deutsche Bank estimates.

Europe’s bigger weakness is its failure to confront the shortcomings of its banks. This is a concern even in stronger economies such as Germany, where the banks have hundreds of billions of euros of exposure to weaker countries including Spain.

There is no sign the Europeans have a plan for shoring up the banks much more involved than heading off sovereign defaults and instituting the pray and delay plan in effect here.

And then there is Spain, which remains something of a cipher. It had a huge housing bubble that collapsed, devastating the construction industry and leaving unemployment at 20%.

Yet Spain arguably is cause for hope. It hasn’t had a huge banking crisis, because strapped borrowers didn’t pig out on home equity loans as they did here. And the government has been trying to fix problems in its labor markets and with the local banks, which Kirkegaard says “have been used as piggy banks by the local politicians.”

The price of privatizing those banks, the cajas that are the target of the Moody’s downgrade Thursday, is a matter of some debate. The government said it will take 15 billion euros to recapitalize them, but private sector estimates run as much as seven times as high, in an unhappy echo of Ireland’s never-ending bank bailout.

Yet even if the worst-case scenario comes to pass with the cajas, the Spanish government appears strong enough to shoulder it. Debt is around 65% of gross domestic product and even a 100 billion-euro bailout amounts to just 10% of GDP.

Contrast this with Ireland, where the debt load is heavier and bank bailout costs are now estimated at a third of GDP.

“I just don’t see a solvency problem with Spain, no matter what happens with the banks,” said Kirkegaard. “With the reforms they are doing, they are on the road to bailing themselves out.”

Wouldn’t that be a welcome change.

Also on Fortune.com:

• Foreclosure vote could rock the banks
• The bailout you can’t remember
• Sheila Bair’s almost bank run

Follow me on Twitter @ColinCBarr.

Filed under: Street Sweep

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The big banks face fresh scrutiny of their handling of the mortgage mess – from their own boards, no less.

Shareholders at Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC) could vote this spring to compel their audit committees to investigate the banks’ mortgage and foreclosure practices, and report back by fall.

Dislikes the micromanaging

The votes will come despite much eye-rolling from the banks, which have tended to be less than forthcoming on the subject. Bank of America and Citi petitioned regulators to keep shareholders from voting on the proposal, which is sponsored by the New York City pension funds led by city comptroller John C. Liu. But the Securities and Exchange Commission ruled this month that the votes must go on.

“An independent examination of bank foreclosure practices is needed to reassure shareholders and protect pensioners and taxpayers,” said Liu, a Democrat who has been pushing since last fall for bank boards to wake up and investigate. “Regrettably, the banks have failed us on this and even went so far as to try and kick us off the ballot, but the shareholders have prevailed.”

The New York funds say they own $1.7 billion worth of stock in BofA, Citi, Wells and JPMorgan Chase (JPM). Its shareholders won’t vote on the New York proposal but will vote on a similar one. Wells initially opposed the New York proposal as similar to one its shareholders were already voting on, but took up the New York measure after the other one was dropped.

Though shareholder proposals rarely pass, the votes will give investors a chance to voice their dissatisfaction with the banks’ handling of the housing crisis. If adopted, the proposal would oblige boards to evaluate the banks’ legal compliance, policies and procedures, staffing adequacy and financial incentives.

The banks have come under fire on all of those fronts over the past six months, with the robo-signing scandal showing the big mortgage servicers regularly flouted state laws in part because their staffing was so thin. Some observers say it could cost tens of billions for the banks to fix their paperwork problems, even if state attorneys general don’t manage to impose a $20 billion penalty on the industry.

The banks’ ineptitude and willingness to bend the rules have led to unnecessary foreclosures that hurt people, damage communities and reduce the public trust, if that’s possible, in bailed-out financial institutions. But as usual, the banks haven’t been cowed by their poor performance.

Citi, for instance, argued before the SEC that it shouldn’t have to let shareholders vote on the proposal, because doing so would “micromanage the company by probing too deeply into matters of a complex nature upon which shareholders, as a group, would not be in a position to make an informed judgment.”

This from an outfit that took, all in, more than $300 billion of assistance from the government during the financial crisis, and recently approved a compensation package that would reward execs over the next two years even if earnings fall from 2010 levels. Lots of informed judgments have been made there, no doubt.

BofA, for its part, argued it had “substantially implemented” the proposal by releasing a mishmash of foreclosure and mortgage information over recent months. But the NYC funds responded that “the fact that the company’s existing internal controls and reviews did not discover any irregularities with its foreclosure processes, until such irregularities became highly publicized in the press, highlight the need for an independent review of the company’s internal controls related to loan modifications, foreclosures and securitizations.”

Both Citi and Wells Fargo have included the proposal in the proxy statements they mailed to shareholders, with the caveat that management is hard set against it — with Wells warning that adopting it could ”distract our efforts to cooperate with reviews undertaken by our federal banking regulators.” Uh huh.

BofA and JPMorgan Chase will surely do the same when they send out their proxies. Getting a hearing on the mortgage mess is surely a small victory, but don’t think for a second that just getting on the ballot is going to make the banks behave.

Also on Fortune.com:

• Blankfein takes the stand
• The bailout you can’t remember
• Sheila Bair’s almost bank run

Follow me on Twitter @ColinCBarr.

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