Debt Infection Continues to Spread

The European debt crisis intensified on Tuesday with borrowing costs surging for Italy and Spain and signs of stress emerging in the key market for lending between banks.

The spreading contagion, which also saw the euro fall below $1.30 for the first time in two months and stock markets edge lower, highlighted the degree to which last weekend's $90 billion bailout of Ireland not only didn't soothe investors' concerns about the ability of the European Union to manage its fiscal and economic strains, but instead served to inflame them.

Reflecting the pressures on Europe's weaker economies, Standard & Poor's said it was reviewing its credit ratings for Portugal, citing a rethink of the country's ability to shore up its fiscal position, as well as the prospect that bondholders might be forced to take losses on future sovereign bailouts. S&P said it would weigh whether to downgrade five Portuguese banks.

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Students in Rome protested an Italian education-reform bill on Tuesday.

European leaders at the weekend meeting attempted to clarify the terms in which bondholders would take losses after mid-2013, but that talk further unsettled investors and sparked questions from credit-ratings providers.

"That's a different set of facts that needs to be analyzed," said John Chambers, chairman of S&P's sovereign-ratings committee. Fitch Ratings' head of sovereign ratings, David Riley, described the talk of so-called haircuts as "a source of uncertainty," while Moody's Investors Service singled out the haircut issue as a concern in a note on Ireland's rating.

Much of the attention Tuesday was on the Italian bond market. Investors have long been skeptical of the outlook for countries such as Ireland, Portugal and Spain. Italy, despite a big debt burden, was seen as less vulnerable to the crisis because it doesn't rely heavily on foreign investors to buy its debt.

But on Tuesday, Italy's cost of borrowing for 10 years jumped to 4.73%, a gap of 2.05 percentage points over the rate paid by Germany, the euro zone's strongest economy. That's up from 1.50 percentage points a week ago.

"The markets have moved quickly from Spain to Italy and that's a real eye-opener," said Gregory Peters, global director of fixed income research at Morgan Stanley. "What Italy represents is a real risk that the crisis moves to the core" of the European Union, he said.

Meanwhile, companies in Europe have seen their own borrowing costs rise substantially. Only about $25 billion worth of new bonds have been sold by European banks in November, compared with the $67 billion sold in November of 2009, according to data provider Dealogic.

The key market for lending between banks also showed evidence of growing strains.

The cost of borrowing U.S. dollars for three months in London rose for the fifth consecutive day to hit 0.3%, its highest level since August. While still below the 0.53% peak hit during Greece's crisis in the spring, and nowhere near 2008's peak, the move was enough to worry investors.

Reflecting the circular nature of the debt crisis, one reason it is costing banks more money to borrow is concern about the value of the European government bonds typically used as collateral for loans and held on the books as capital reserves, said John Brady, senior vice president of global interest rate products at MF Global.

"The credit spiral is getting worse," Mr. Brady said.

In another reflection of the expanding concern, the cost of insuring government bonds of Portugal, Belgium, France, Spain and Italy, hit record highs on Tuesday, according to data provider Markit. It now costs $271,000 a year to insure $10 million of Italian government bonds for five years, a jump of $26,000 from a day earlier.

While Italy's annual budget deficit is much smaller than some of its euro peers, its overall debt burden is the biggest in the euro zone after Greece as a proportion of its economic output, according to the International Monetary Fund. Like Portugal, Italy faces a tough slog of slow economic growth, which will make it hard to pay back its debts. And observers say there are concerns about its increasingly cloudy political climate. Some fear that Prime Minister Silvio Berlusconi could lose a crucial confidence vote this month, which could delay needed economic reforms.

The euro zone faces more challenges in the coming days. On Wednesday and Thursday, Portugal and Spain will be selling fresh debt to investors, while the European Central Bank will hold a widely watched meeting on Thursday.

Mr. Riley suggested that one solution for the ECB would be to increase purchases of European sovereign debt, which he described as "small, really, during the crisis."

Morgan Stanley's Mr. Peters said odds are that the ECB will continue its recent stance of declining to prop up the European government-bond markets to any great degree.

"I think they'll disappoint the market and what will ultimately happen is what happened in the spring when the downward pressure on the markets will finally prompt them to take action," he said.