Italy's credit rating was cut by Standard & Poor's, thecountry's first downgrade in five years, as Greece's worseningfiscal crisis fans concern that contagion will engulf countriessuch as Spain and Italy.

S&P lowered its rating last night to A from A+, saying weakeconomic growth, a “fragile” government and rising borrowing costswould make it difficult to reduce Europe's second-biggest debt. Theyield on Italy's 10-year bond rose 8 basis points to 5.662 percent,385 basis points more than similar German debt. The cost ofinsuring Italy against default rose to a record.

The European Central Bank was forced to buy Italian and Spanishbonds last month after their yields surged to euro-era records onconcern they'll be the next victims of the two-year-old debt crisisthat led to bailouts for Greece, Ireland and Portugal. Moody'sInvestors Service is set to decide in the next month whether todowngrade Italy and Spain, while Greece struggles to convinceinternational creditors it deserves its next bailout payment tostave off a default.

“Investors have become more bearish about Italy mainly becauseeuro-zone leaders failed to create a firewall around the bloc'ssolvent governments,” said Nicholas Spiro, head of Spiro SovereignStrategy, a London-based consulting firm. “They let a crisis in thenarrow periphery of the euro zone morph into one affecting thesolvent core” and “we're now dealing with the consequences.”

Greek Talks
European Union and InternationalMonetary Fund officials held a second conference call in as manydays tonight with Greek Finance Minister Evangelos Venizelos, whois try to convince them that Greece deserves the sixth payment ofits original 110 billion-euro bailout.

Italy follows Spain, Ireland, Portugal, Cyprus and Greece aseuro-region countries having their credit rating cut this year.Prime Minister Silvio Berlusconi passed a 54 billion-euro ($74billion) austerity package this month that convinced the ECB to buyits bonds. The plan to balance the budget in 2013 wasn't enough tosway S&P, whose rating on Italy remains five steps abovenon-investment grade and three below that given by Moody's.

Speculation, Reality
“The valuations ofStandard & Poor's seem dictated more by newspaper speculationthan by reality, and appear influenced by politicalconsiderations,” Berlusconi's office said in an e-mailed statement,adding that the government will meet its budget targets as itprepares measures to boost economic growth.

Responding to the government's statement, S&P said itsrating was based on an independent analysis of Italy's fiscal andeconomic outlook and debt prospects. “S&P's sovereign ratingsare apolitical” and indicate “how different political initiativesmay impact financial accountability,” the rating company said in ane-mailed statement.

The jump in Italy's yields threatens to raise borrowing costs asthe country prepares to sell more debt. Italy still needs to sellmore than 50 billion euros of bonds this year, with the threeauctions set for next week starting on Sept. 27.

Spain sold 4.46 billion euros of 12-month and 18-month bills,just below its maximum target, and its borrowing costs rose even asthe ECB moved to support the nation's debt.

ECB Purchases
The ECB purchased more Spanishand Italian bonds today, according to five people with knowledge ofthe transactions. The yield on Spain's benchmark 10-year bond,which reached a euro-era high of 6.3 percent on July 18, was littlechanged after the auction at 5.36 percent.

The worsening debt crisis is also eroding confidence among theregion's banks, crimping liquidity and pushing the spread betweensecured and unsecured interest rates to the widest since December2008. The ECB said on Sept. 15 it will lend dollars to euro-areabanks with the Federal Reserve and other central banks to ensureaccess to the U.S. currency.

“There's real doubt whether all countries can manage their debtsand how the European banking system can withstand the crisis,”Finland's Prime Minister Jyrki Katainen said in a televisioninterview on Finland's MTV3 today.

S&P warned that it may cut its rating on Italy's bank whenit first put the country's creditworthiness on review in May.UniCredit SpA, Italy's largest bank, has lost more than half itsvalue this year on concern over its holdings of Italian debt.Intesa Sanpaolo SpA, the No. 2 bank, is down 44 percent in2011.

U.S. Rating
The Italian decision also comesjust weeks after S&P stripped the U.S. of its AAA rating forthe first time. While the Aug. 5 move roiled global markets, bondinvestors ignored S&P's warnings about U.S. creditworthinessand piled into Treasuries. The yield on the benchmark U.S.government bond fell to a record 1.8770 on Sept. 12.

S&P said it lowered its outlook for Italy's growth to a 0.7percent annual average for 2011 to 2014, from a prior projection of1.3 percent. The slowing economy will make it harder for Italy toachieve its fiscal targets, the rating company said.

“The high level of public debt leaves Italy on an unstableequilibrium,” Barclays Capital Research economists including JulianCallow said in an e-mailed note today. The government has not comeup with any “structural reforms” to improve long-term economicgrowth prospects and is unlikely for now “to deliver on thisfront.”

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