By Walter Brandimarte and Carmel Crimmins
NEW YORK/DUBLIN (Reuters) - Moody's cut Ireland's credit rating to junk on Tuesday, warning that the debt-laden country would likely need a second bailout -- just the latest move amid heightening concerns about Europe's ability to address its debt crisis and prevent it from spreading.
Moody's move comes a week after it slashed Portugal to junk status with a similar warning about the need for a second round of rescue funds. It reflects the credit rating agency's view that any further financial assistance from Brussels will require private investors to share part of the pain, possibly through a debt rollover or swap.
European finance ministers have acknowledged for the first time that some form of Greek default may be needed to cut Athens' debts, and if that materializes, Ireland's rating, never before in junk territory, could be set for a further round of cuts.
Investors fear a Greece default could ripple through Europe's banking system, putting pressure on stretched public finances in other euro zone countries. Italy, the euro zone's third largest economy, looks especially vulnerable with a debt-to-output ratio second only to Greece, and markets fear political bickering may derail a plan to slash spending and rein in the deficit.
Moody's one-notch downgrade on Ireland weighed on stocks and the euro, which hit its lowest level against the dollar in four months.
The Irish government, which wants to return to debt markets in 2013 when its current EU-IMF bailout runs out, offered a vexed response.
"This is a disappointing development and it is completely at odds with the recent views of other rating agencies," the finance ministry said in a statement. "We are doing all that we can to put our house in order and the progress that we are making is there for all to see."
Moody's now rates Ireland Ba1, one notch below former financial market pariah Colombia and two notches below Brazil, and has kept a negative outlook, meaning further downgrades are likely in the next 12 to 18 months.
Ireland's rating is still one notch above Portugal and six above Greece. Both Standard & Poor's and Fitch Ratings have Ireland at BBB-plus, three notches above junk status, with S&P's outlook stable and Fitch on outlook negative meaning it does not expect a downgrade in the short-term.
Moody's move, however, will likely put pressure on the other ratings as the downgrade forces some investors to dump Irish bonds because they no longer enjoy a clean investment-grade sweep of the three major ratings agencies.
"It's amazing to me that Ireland was still investment grade," said Suvrat Prakash, interest rate strategist at BNP Paribas in New York.
"A lot of people assume that these rating agencies tend to move with a lag so there could be more downgrades to come.
Ireland's borrowing costs are already at levels once thought unimaginable, with five-year paper yielding over 15 percent on the secondary market and 10-year paper close to euro-era highs of 13.86 percent.
When Ireland agreed an 85 billion euros ($119 billion) bailout package with the European Union and the International Monetary Fund last November -- a move designed to soothe market fears -- its 10-year paper was yielding around 9.5 percent, a level viewed as shocking at the time.
Economic growth in the European region as a whole has been sluggish, as a number of nations have struggled with mounting debt costs and have had to pass harsh austerity plans that have slowed economic growth further, creating a vicious cycle where tax revenues drop, reducing their chances of repaying the debt even more.
But the more investors fear that heavily indebted euro zone governments will be unable to repay their debts, the more the yields on their bonds rise, dragging down their value in banks' balance sheets, erasing their capital, and increasing the need for yet more bank bailout's by stronger euro zone governments.
A CORK BOBBING IN THE OCEAN
Unlike Greece, Ireland is meeting its bailout targets and Irish officials have felt frustrated at how their efforts have been swept aside by events in Athens.
An agreement by the euro zone finance ministers, known as the Eurogroup, late on Monday to cut the interest rate for countries borrowing from their rescue fund and an agreement to make the fund more flexible and extend its loan maturities was hailed by Dublin as helping it return to debt markets.
The finance ministry said Moody's move appeared not to reflect the Eurogroup developments, but Moody's analyst Dietmar Hornung said the risk of private sector participation in any future bailout meant investors would be put off lending fresh funds to Ireland.
Hornung, in an interview with Reuters, warned over the risks even though Moody's is confident the euro zone is "willing to continue to provide liquidity support for peripheral countries and give them time to achieve a sustainable financial position.
"But at the same time we see a growing possibility that, as a precondition of additional rounds of liquidity support here, private-sector creditors participation will be required," he said.
Ireland's debt management agency said on Tuesday the country was fully funded until the end of 2013. Ireland has a financing requirement of nearly 34 billion euros over 2014 and 2015, based on estimated deficits and maturing debts.
Even before Moody's downgrade, Finance Minister Michael Noonan admitted Dublin was at the mercy of the markets.
"Ireland is a cork bobbing on a very turbulent ocean at present," he told state broadcaster RTE on Tuesday.
Officials from the EU, the IMF and the European Central Bank are expected to confirm Dublin is meeting all its bailout targets in their latest quarterly review, expected on Thursday.
But Ireland's weak domestic economy is hitting spending-related tax revenues, and Moody's warned that another downgrade would be considered if the government can't meet its fiscal consolidation goals.
(Reporting by Walter Brandimaret and Carmel Crimmins; Additional reporting by Daniel Bases; Writing by Carmel Crimmins; Editing by Leslie Adler)