Rating agency Standard and Poor's slashed Greek debt to junk status on Tuesday and also downgraded Portugal, as investors worried political pressures could block a multi-billion euro bailout of Greece.
Markets in Europe and the United States tumbled in reaction to signs that the Greek debt crisis was spreading to other highly indebted states on the periphery of the euro zone.
It's contagion from the Greece crisis which has spiraled out of control, said William Sullivan at JVB Financial Group in Florida.
It's like coconuts falling from the tree. There's a flight from sovereign debt issuers that have suspect national finances.
Sullivan said there was outright panic among investors who feared they would lose some of their principal if Greece restructured or defaulted on its 300 billion euro debt.
Greece has entered a death spiral of government insolvency, Thomas Mayer, chief economist at Deutsche Bank, Germany's largest bank, said late on Monday in remarks withheld for release on Tuesday.
S&P cut its rating of Greek government debt by a full three notches to BB-plus, the first level of speculative status. The outlook is negative, meaning the agency could downgrade Greece again.
The downgrade put Greece on par with Romania and below Kazakhstan, Hungary and Iceland, the last of which rocked global markets when its main banks imploded at the start of the global financial crisis.
S&P cited the political, economic, and budgetary challenges that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory.
For Portugal, S&P cut its rating by two notches to A-minus, saying Portuguese finances were structurally weak and the economy uncompetitive. Lisbon needs to do more than it currently plans to stabilize its finances, S&P said.
Bailout talks between Greece, European authorities and the International Monetary Fund began in Athens last week, after Greece asked for as much as 45 billion euros in emergency loans from euro zone governments and the IMF this year.
Greek and European Commission officials have said the first tranche of aid will be paid before May 19, when Athens will need to refinance a maturing 8.5 billion euro bond.
But the markets are not convinced that governments have the political will to reach and sustain an agreement on the aid, especially in Germany, where public opinion is strongly against helping Greece.
The backing of Germany, Europe's biggest economy, is vital for any rescue but Chancellor Angela Merkel's Christian Democrats risk defeat in a regional election on May 9 that would end her coalition's majority in the upper house of parliament.
To rally support among their taxpayers for a bailout, European governments want Greece to commit to tough austerity steps. But they cannot push too hard since that might hurt Greek public support for austerity, and by deepening Greece's recession, make deficit-cutting targets impossible to hit.
Juergen Koppelin, a budget official in the junior party of the German ruling coalition, the Free Democrats, said on Tuesday Germany's contribution to the rescue was not guaranteed.
And although the European Commission insists the bailout of Greece will not involve restructuring its debt, the Christian Democrats' budget spokesman said on Tuesday that his party would raise the idea of forcing investors to take a discount on Greek debt with the IMF and the European Central Bank on Wednesday.
Norbert Barthle said banks holding Greek debt should have to contribute to a rescue as they had profited from the crisis and speculated against Greece in part.
In Athens on Tuesday, about 1,500 private and public sector workers, students and anarchists marched to parliament chanting Out with the IMF and the European Union in protest against austerity measures that could accompany the bailout.
Most Greeks disapprove of their government's decision to ask for financial aid, according to the first opinion poll since the request was made. Of 1,400 people surveyed, 60.9 percent said they were against the decision, said the poll, released on Tuesday by Greek Public Opinion for Mega TV.
U.S. crude oil futures sank more than 2 percent in response to the downgrades of Greece and Portugal, while the euro fell back near a one-year low against the U.S. dollar. Britain's FTSE 100 share index dropped 2.6 percent.
Greek bank stocks plunged more than 9 percent. The Greek bank index has lost nearly 60 percent since the debt crisis began to develop in mid-October, destroying about 28 billion euros in market capitalization.
As other banks have cut funding lines to them during the crisis, Greek banks have become heavily dependent on funding which they obtain from the ECB in money market operations.
ECB rules mean that after S&P's action, any large downgrade by another agency, Moody's Investors Service, could worsen Greek banks' funding problems.
If Moody's, which now rates Greece A3, also cuts Greece to BBB territory, banks will receive 5 percent less cash when they use Greek bonds as collateral in money market operations.
Greece's two-year government bond yield soared to nearly 15 percent on Tuesday, meaning any fresh borrowing from the debt market would be ruinously expensive for Greece. Trade in its bonds has almost halted as bid/ask spreads have ballooned to prohibitive levels.
The two-year Portuguese government bond yield jumped to 5.23 percent from 4.16 percent, as the cost of insuring its debt against default rose to a record high.
Even if Greece obtains international aid this year and over the next few years, many analysts think its uncompetitive economy may continue to struggle in the euro zone's monetary straightjacket, ultimately forcing a debt default.
A Reuters poll of about 50 economists last week found them estimating a 23 percent chance of a Greek default within five years.
S&P on Tuesday assigned a recovery rating of 4 to Greece's debt, indicating it expected an average recovery of between 30 and 50 percent for holders in the event of a Greek restructuring or default.
(Additional reporting by Athens bureau, London markets team, and Dave Graham in Berlin; Writing by Tim Heritage and Andrew Torchia; Editing by John Stonestreet, Ron Askew)