Since August 2007, credit markets have witnessed an unprecedented repricing of credit risk. This credit market crisis has proceeded in several stages and has affected all sectors. The revaluation started in US mortgage markets; subsequently corporates, in particular banks, underwent a dramatic reassessment of their credit risk. This financial market turbulence reached a peak in the wake of the collapse of Lehman Brothers in September 2008. After this event, many major banks on both sides of the Atlantic were in major distress and massive state intervention was required in order to mitigate systemic risk and its adverse macroeconomic consequences.
Since September 2008, the sovereign debt market has attracted considerable attention. Before the crisis, trading in credit markets was concentrated on private sector instruments such as corporate credit risk or securitisation instruments. The collapse of Lehman Brothers in fall 2008 led to a fundamental reassessment of the default risk of developed country sovereigns. Widespread and large-scale state support for banks as well as other stimulus measures to the broader economy quickly increased public sector deficits to levels last seen after World War II. For example, in the UK the fiscal burden of extensive bank support measures is estimated at 44% of UK GDP (Panetta et al, 2009).
In the euro area, sovereign debt markets in several countries came under unprecedented stress in the first half of 2010. Massive sell-offs were observed for instance in Greek government bonds, with CDS spreads on Greek bonds jumping above 1,000 basis points. These tensions peaked in a „flight to safety episode in early May 2010, when investors started large scale sell-offs of risky assets. European public authorities then announced a number of measures to reduce distress in financial markets.
In particular, EU finance ministers launched the European Financial Stability Facility (EFSF), while the ECB announced several policy measures such as interventions in bond markets under the Securities Markets Programme. The EFSF with a planned overall volume up to EUR 440 billion is intended to support euro area governments which face difficulties in accessing public debt markets (cf. Deutsche Bank, 2010). These measures all helped improving sentiment in euro area sovereign debt markets.
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An Analysis of Euro Area Sovereign CDS and their Relation with Government Bonds
