Crisis in Europe: Prepare for Repercussions from Standard & Poor's Credit Rating Downgrades

After months of buzz about how the debt crisis in Europe will trigger credit ratings cuts, Standard & Poor's today (Friday) issued credit rating downgrades for at least three European countries.

France and Austria were both lowered one notch to AA-plus. According to an Italian news agency, Italy was also going to be lowered two notches to BBB-plus.

A source told Reuters that Spain and Portugal also face downgrades.

"Remain alert tonight when U.S. markets close," the Eurozone source told the news agency.

The markets had mostly priced in the moves, but the euro still fell 1% to trade at $1.2679. The euro had rallied Thursday after a sale of Spanish and Italian bonds was met with stronger demand than expected.

While S&P downgrades for debt-stricken Eurozone countries were expected, the move could lead to a credit ratings cut for the European Financial Stability Fund (EFSF), the main lender behind country's suffering from the European debt crisis.

"The main problem is on the European Financial Stability Fund, the facility that borrows to lend to the naughty PIIGS," said Money Morning Global Investing Strategist Martin Hutchinson. "That has been AAA rated, but since it depends on Eurozone country guarantees, if the countries are downgraded it may no longer qualify as AAA."

If EFSF is downgraded, it will have a much harder time financing the aid packages it has promised to Greece, Italy, and Spain. Germany is now the only large AAA-rated country underwriting the EFSF, which will try to raise $1.9 billion (1.5 billion euros) Tuesday in a bond auction.

Even though France remains rated AAA by other agencies, that status could also change. Fitch Ratings Inc. has it on "negative" outlook and Moody's Corp. (NYSE: MCO) announced in October it would review the country's rating.

The biggest concern behind the Europe downgrades is the global financial domino effect that the move triggers.

"The real issue is one of repercussions - when ratings drop there will corresponding triggers in credit default swaps, currency swaps and collateral requirements at clearing firms worldwide," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Perfecting collateral could become the thing that actually sends the banking system into anaphylactic shock rather than the ratings themselves - especially since much of the rehypothecation was done presuming certain credit quality of the underlying instruments."

Rehypothecation is the process of banks loaning out money deposited as collateral. Fitz-Gerald detailed the damaging effects of banks' rehypothecation in a recent Money Morning article, "How Banks Are Using Your Money to Create the Next Crash."

Fitz-Gerald said with so many banks lending out money deposited as collateral, they're creating a "daisy chain" where one banks' liabilities become another's assets.

"If there is a hiccup anywhere in the chain, the effect is one of instant collateral collapse as everybody in the chain is forced to buy back, or recall, their assets. The effect is not unlike a colossal global "short" on world markets," said Fitz-Gerald.

More "hiccups in the chain" are surely on the way as the crisis in Europe continues, and Fitz-Gerald offered the following advice for investors.

"Short specific banks or the broader financial sector as a whole. But be prepared for a bumpy ride," Fitz-Gerald said. "Also, continually ratchet up trailing stops to protect gains. Why the markets rally is not important, that you capture profits as they do is. It is absolutely possible to be a market bull and an economic bear."

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