There are various legitimate reasons why European banks have been dumping their exposure to European periphery sovereign debt - with yields on Italian and Spanish bonds soaring as a result - with one of the factors that has been getting more attention recently has been the banks' loss of confidence in the sovereign credit default swap market.
The trigger here has been the deal struck in late October to restructure Greek debt with a 50% write-down of Greek bonds. Despite such a large haircut - which would in normal circumstances be considered a default and therefore pay out the insurance purchased under a credit default swap contract - the European leaders were able to finesse the details and by having banks agree to a voluntary restructuring able to avoid this credit event.
Gillian Tett of the Financial Times explains well:
From Financial Times: But Greece, it seems, is different from Dynegy; at least, under ISDA rules. When the eurozone leaders announced their plans to restructure Greek bonds they failed to meet - or, more accurately, deliberately missed - the fine print of default under ISDA rules. Most notably, the standard ISDA sovereign CDS contract says that pay-outs can only be made when a restructuring is mandatory, or a collective action clause invoked. However, it seems that 90 per cent of Greek government bonds do not have collective action clauses; and the October 26 announcement presented the haircut as voluntary. Thus ISDA has concluded that the exchange is not binding on all debt holders, so the CDS cannot be activated - even though losses on Greek bonds may well be bigger than at Dynegy.
Many investors, unsurprisingly, are outraged; some observers, such as Janet Tavakoli, a consultant, conclude that the saga has exposed the CDS market as a sham, with ISDA acting in bad faith. But ISDA officials vehemently deny this - and insist that the blame lies with eurozone leaders, and their determination to manipulate the fine print of the rules.
Up until the October 26th agreement, credit default swaps had been used by banks as a hedge against their periphery exposure, meaning they didn't necessarily have to offload their a bonds in order to minimize risks to their balance sheets, but just buy a corresponding amount of CDS. The template set in the Greek restructuring has upset the apple cart here and as a result banks - fearing that those CDS may not pay out using the Greek model - have instead insisted on selling their bonds out right.
From Marketwatch: The plan raised the issue of whether the CDS market any longer provides a realistic way of hedging European sovereign or European bank credit risk, said Christopher Wood, equity strategist for CLSA in Hong Kong, in commentary last week. At the same time, the CDS spreads on several countries jumped. The debt of France, Belgium and the Netherlands have also come under attack in recent days as more investors worry about the futility of CDS as a hedging tool.
Now, without that hedging option, traders may simply demand a higher yield from debtors - exactly what Europe's deal was intended to avoid. Going forward, people are going to demand a higher yield on other sovereign credits, especially in the euro zone, because they can't be sure their assumptions in terms of risk management are the same as they were previous to the Greek deal, he said.
While European leaders would like the markets believe that the Greek situation is a unique one and would not be repeated for other periphery members, the concern is certainly out there that the Greece deal will be a model to follow considering the debt restructuring that may be needed in other periphery countries.
Even removing the CDS issue, European banks have grown suspicious that the prinicipal on periphery bonds will be paid back at par value. If you add in the prospect of the main hedge for such an event may not be useful, then it certainly goes to the heart of why we have seen a sharp sell-off in periphery debt the last month.
From Zerohedge: Banks are selling because they own too much sovereign debt. Many of the banks own that debt at par. They owned the debt with the conviction that it would eventually be paid back at par. Most assumed it would be paid back at par on the originally scheduled maturity date, but figured, even if the maturities were extended, they could finance the positions for almost free with the ECB and not be hurt too badly. Now they couldn't hide behind that view. It was clear to all that they might not get paid par for the bonds they held, and even worse, the decision might be taken out of their hands.