Stocks tumbled 3 percent on Wednesday, erasing gains for the week so far, as a spike in Italian bond yields fanned worries about contagion in the European debt crisis.

All 10 S&P sectors were down, though S&P financials were the hardest hit. The index dropped 4.4 percent as investors dumped bank stocks on concerns about exposure to European debt. The KBW Bank index fell 3.8 percent.

Italian bond yields shot up to 7.502 percent, a new high since the euro was introduced in 1999, as investors unloaded the debt after a clearing house increased margin calls. Prime Minister Silvio Berlusconi's insistence on elections instead of an interim government raised concerns of prolonged instability and delays to economic reform.

Markets are trying to come to grips with what's happening here and what could be the possible ramifications, said Robbert Van Batenburg, head of equity research at Louis Capital in New York.

We still don't have any clarity ... and you're dealing with a very fluid situation where politics takes center stage.

Italy has replaced Greece at the center of the euro zone debt crisis and is seen teetering on the cusp of requiring a bailout. Portugal and Ireland were forced to seek bailouts when their borrowing costs reached similar levels.

The Dow Jones industrial average was down 426.70 points, or 3.51 percent, at 11,743.48. The Standard & Poor's 500 Index was down 48.47 points, or 3.80 percent, at 1,227.45. The Nasdaq Composite Index was down 106.75 points, or 3.91 percent, at 2,620.74.

Reflecting growing market anxiety, the CBOE Volatility Index VIX jumped 30 percent, its biggest daily percentage jump since mid-August. The index usually moves inversely to the S&P 500 as traders use it as a hedge against falling stocks.

Italian bonds are essentially serving as another fear index like the VIX, and right now they're reflecting a lot of fear, said Charles Reinhard, deputy chief investment officer at Morgan Stanley Smith Barney in New York.

Among bank stocks, Morgan Stanley fell 8.5 percent to $15.85.

(Reporting by Caroline Valetkevitch and Angela Moon, additional reporting by Ryan Vlastelica; Editing by Kenneth Barry)

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