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LONDON (Reuters) - Banks acting as primary dealers of Italian debt are growing uncomfortable with their obligation to buy at bond auctions as the euro zone crisis worsens, increasing the risk that Italy fails to raise enough cash to stay afloat.
Since October, Italy's borrowing costs have risen to levels deemed unsustainable, making long-term investors reluctant to buy and increasing the risk that the banks able to bid at auctions are left holding a rapidly depreciating stock of bonds.
Borrowing via debt auctions is vital if governments are to cover their budget deficits. Italy plans gross debt issuance of around 440 billion euros next year.
The 20 specialist primary dealer banks granted the exclusive right to buy at Italian auctions, with a view to selling on to clients, used to be envied for the preferential treatment they received in the world's third largest debt market.
That treatment came in return for commitments such as buying at least 3 percent of Italy's annual debt issuance and bidding for bonds in high volumes in the secondary market to ensure a liquid and smoothly functioning market. Another group of primary dealers has only market-making obligations.
Those commitments posed few problems during pre-crisis years. But as the bloc's debt problems have escalated, demand for Italian bonds has dried up and primary dealers are often stuck with hefty amounts of debt that is rapidly losing value.
"The primary dealers are finding it hard because the banks aren't making money and the tail risks are huge, volatility is bad ... All this points toward failed auctions," said a senior source at a primary dealer, who asked not to be named. The primary dealers have confidentiality agreements with the Treasury.
"People will be reassessing which sovereigns they are dedicated to in 2012 and how much they are willing to dedicate to that," the source said.
If dealers submitted insufficient bids to allow Italy to sell its targeted amount of debt, the auction would be deemed a failure -- a further blow to the country's funding credibility.
In theory, if the 20 specialist primary dealers decided to limit their exposure to Italian debt by only bidding for the minimum 3 percent, Italy could only sell 60 percent of next year's target.
The Italian Treasury was not immediately available for comment.
The fear that the euro zone debt crisis could spiral out of control is keeping traditional government bond investors, such as pension funds and insurance companies, sidelined and ramping up pressure on primary dealers to buy Italy's debt.
If pressure increases further, it could lead to a "buyers' strike," one trader at a primary dealer said.
The European Central Bank, which has been buying Italian and other highly indebted euro zone governments' debt in a bid to keep borrowing costs down, could reduce the risk of a strike by signaling it would significantly step up its secondary market purchases, giving primary dealers a ready buyer.
"There's really only the ECB that can change things. In the UK, dealers participate in auctions with the view to banging it out at the next buy-back," the trader said.
Despite the growing risks, maintaining primary dealer status may still have longer-term benefits.
Primary dealers get exclusive rights at some auctions and, based on their performance as a market maker, Italy may choose them to lead manage syndicated debt sales -- transactions for which they usually earn a sizeable commission.
Even though client appetite to hold new Italian bonds is waning and the market for syndicated debt has shrunk, the primary dealer sources said they would be more likely to reduce their support, rather than withdraw it entirely.
There are also strategic reasons to remain involved, such as access to more information than their competitors related to market flows and better access to policymakers.
"If you want to be in it, relevant, heard, have access to politicians and ministries of finance, to be part of the debate, and to be relevant therefore also to your clients ... then you don't really have a lot of choice," the senior source said.
For the three Italian domestic banks with primary dealer status, the incentive to give full support to a debt auction is even greater given that, if allowed to worsen, the sovereign debt crisis could evolve into a banking crisis.
"In this day and age the whole banking and sovereign sectors are so intertwined that on any given day if you're a domestic (bank), the balance of dependence can switch very quickly," said another source at a primary dealer.
"In the event of a failure banks are going to be looking toward the domestic sovereign to support them."
Graphics by Scott Barber, Vincent Flassur and Valentina Za, additional reporting by Valentina Za in Milan, writing by Marius Zaharia, editing by Nigel Stephenson