The threat abruptly ended a relief rally in stock and bond markets after Greece adopted a new, tougher austerity plan last week, prompting euro zone finance ministers to agree on Saturday to throw Athens a 12 billion euro short-term lifeline.
Bank stocks fell in Europe [.SX7P 189.56 --- UNCH (0)] and the cost of insuring Greek debt against default resumed an inexorable climb only briefly interrupted last week when the Greek parliament backed a new wave of spending cuts, tax rises and public asset sales.
Investors fear that a default by Greece, which has seen violent protests against austerity, would send shockwaves through the world finance system with some analysts saying it could call the whole euro zone into question.
While S&P's statement did not deal a death blow to the complex French rollover plan — seen by critics as a bailout for creditor banks rather than for Greece — it highlighted the difficulty of arranging private sector involvement in a second rescue package.
"It is our view that each of the two financing options described in the (French banks') proposal would likely amount to a default under our criteria," S&P said in a statement.
North European creditor nations, led by Germany, are insisting that banks and insurers must share the burden of any new financial support for Greece, which is estimated to need some 120 billion euros in new funding until end-2014.
French banks, major holders of Greek sovereign debt, proposed voluntarily renewing some of the bonds when they mature but on different terms.
Many investors and economists believe Greece will have to restructure its debt in the medium-term and the bailouts are only buying time and shifting the eventual cost from banks to taxpayers.
"The relief that we had last week with the votes is now somewhat put on the back-burner by this news (from S&P)," said Marc Ostwald, strategist at Monument Securities. "It would be nice to have some more details on it."
Confidence Punctured
S&P has been the most hawkish agency recently on Greece, downgrading its sovereign rating to CCC last month from B on a view that any restructuring of its 340 billion euro debt pile — 150 percent of annual economic output and rising — would count as an effective default.
The statement punctured some of the confidence voiced last week by bankers and public officials involved in the talks that the French proposal, seen as a template for other European private bondholders, would not trigger a default.
However, Fitch Ratings has hinted it may not be so severe and may avoid downgrading Greek debt to default after the transaction period, leaving the European Central Bank a chance to go on accepting the bonds as collateral in refinancing operations.
Under its standard procedure, the ECB bases its decisions on the rating agency that offers the highest rating, even if it is alone.
ECB officials have declined comment on how they would behave in this case but ECB policymaker Lorenzo Bini Smaghi has said the bank will not break its own rules.
S&P said it would assign a new rating "after a short time" once the debt rollover plan was actually be implemented, adding that the new rating would be forward-looking and reflect Greece's new sovereign credit situation.
It stopped short, however, of saying unequivocally the new rating would take Greece out of default, whereas Fitch said in a statement last month that its new rating, once the plan would be implemented, would take Greece out of restricted default.
Bankers and officials say negotiations on the bank rollover plan are still under way, with German authorities and banks seeking some changes to the French model, and a solution may take several weeks.
S&P itself said changes to the plan could alter its judgment.
"S&P's quick reaction to the French model is positive, because it gives guidance to the German banks what parts they need to modify to avoid a default in any shape or form.
It's an important pointer," Germany's public banks said in a statement.
Finance ministers of the 17-nation currency area are due to agree on the outlines of the second Greek rescue package, after last year's 110 billion euro bailout, at a meeting in Brussels next week, but details will not be signed off until September.
A senior Greek bank executive played down the S&P setback.
"If the 'selective default' period is short, covering just the settlement period for the bond exchange to take place, then there would be no funding issue for Greek banks," the banker, who declined to be named, told Reuters.
Uphill Struggle
Greece faces an uphill struggle this week to start the process of selling off state-owned assets and reform its tax system to meet European Union and IMF bailout conditions.
Jean-Claude Juncker, the chairman of euro zone finance ministers, said Athens faced a severe loss of its sovereignty with increasingly intrusive outside supervision of its fiscal policy and privatization agency.
The deep spending cuts required under the loan terms have sparked angry protests on the streets of Athens where hooded youths have fought running battles with riot police.
"The initiatives that must be undertaken in the coming days and weeks have only one goal, to resurrect the economy, halt recession and return to growth for the benefit of all citizens and mainly the unemployed and weak income groups," combative Finance Minister Evangelos Venizelos said on Monday.
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