S&P downgrades Greece rating; Ireland, Spain maybe next

Credit-default swaps on Portugal rose 13.5 basis points to 121 basis points after S&P's move, up from about 40 basis points in September. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. An increase signals deterioration in the perception of credit quality; a decrease, the opposite.

There is an “increasing disparity and deterioration in the quality of European sovereigns,” Emma Lawson, a currency strategist in London at Merrill Lynch, wrote in a report yesterday.

Five-year credit-default swaps on Mexico have fallen 81 basis points to 309 since Oct. 13, CMA data show. Contracts on Vietnam have dropped 22 basis points to 436 basis points.

Ireland has the highest credit-default swaps for a AAA rated nation in the European Union at 217 basis points, CMA data show. Italy is the highest of the AA's, trading at 167.5, and Estonia, rated A by S&P, is at 523.

Bond Yields

Yields on the bonds of smaller European economies, such as Spain, Italy and Greece, have risen to the highest relative to German bunds since before the ECB was established a decade ago. Spanish 10-year notes yield 99 basis points more than bunds, up from 17 basis points one year ago. For Italian notes, the gap almost quadrupled to 141 basis points from 36 basis points.

"Much of the rationale behind these moves has been focused on the risk of a breakup in the euro or a specific country being ejected from the union,” Charles Diebel, the head of European interest-rate strategy at Nomura International Plc, wrote in a note to clients. “This makes little sense and is not a valid risk scenario at this point in time.”

Budget deficits are rising across the euro region as Europe faces a recession that may be the worst since World War II. The economy will shrink 1.8 percent in 2009, twice as much as in 1993 and four times what the ECB forecast last month, Royal Bank of Scotland Group Plc economist Jacques Cailloux in London wrote in a report to clients yesterday.

Rate Cuts

The slump is putting the ECB under pressure to cut its key interest rate again this week even after it reduced it by 1.75 percentage point since early October. The Federal Reserve has already cut its target rate for overnight loans between banks to as low as zero.

"The ECB is behind the curve in its rates policies and the sooner this can be corrected, the better,” Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London and part of the shadow ECB, said in an e-mailed report yesterday.

Spanish Finance Minister Pedro Solbes said Jan. 13 that the country's budget deficit will “substantially” exceed the European Union's limit of 3 percent of GDP this year.

Europe's downturn may take the biggest toll on countries already saddled by debt. Italy's burden rose to 109 percent of gross domestic product in October, the highest in the euro region, and the International Monetary Fund in Washington estimates that will limit Prime Minister Silvio Berlusconi's ability to revive the economy.

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