S&P credit watch on 15 eurozone nations, bailout fund

— -- Standard & Poor's threat to downgrade 15 eurozone countries, including Germany, as well as Europe's bailout fund has added pressure on the region's leaders to find a lasting solution to their crisis at a summit this week.

German Chancellor Angela Merkel on Tuesday downplayed S&P's warning, but the possibility that a downgrade of eurozone countries could also weaken the creditworthiness of Europe's bailout fund complicates the region's fight against the crisis.

The first warning on Monday came just hours after Merkel and French President Nicolas Sarkozy urged changes to the European Union treaty that would centralize decision-making on spending and borrowing for the 17 countries that use the euro. Tighter political and economic coordination among euro countries is seen as a precursor to further financial aid from the European Central Bank, the International Monetary Fund, or some combination.

S&P's threat to cut Germany's prized AAA rating was particularly surprising. Its bonds are considered among the safest in the world and are the basis upon which Europe finances its bailout fund. S&P warned in a follow-up report that it could cut the AAA rating of Europe's bailout fund by up to two notches if it decides to downgrade one of the eurozone's top-rated countries.

The bailout fund needs the AAA rating to cheaply raise money on markets. Losing it would mean it would cost billions more to fund bailouts, hurting the rescued countries that ultimately have to pay the higher interest rates.

Investors mostly took the S&P warnings in stride on Tuesday. European stocks and bonds held onto the gains they made Monday.

"What a rating agency does is the responsibility of the rating agency," Merkel told reporters in Berlin, refusing to elaborate further.

She said, however, that she expected a meeting of European leaders later this week in Brussels would help restore markets' confidence.

She and Sarkozy on Monday outlined sweeping plans to change the EU treaty in an effort to keep tighter checks on overspending nations. The proposal is set to form the basis of discussions at an EU summit in Brussels on Friday.

The financial markets of Italy and Spain rallied after Merkel and Sarkozy unveiled their proposals, suggesting investor are more confident Europe can survive the crisis.

"I have always said this is a long process and an arduous one and it will continue, but we charted the course yesterday with the French president and we will continue to stay the course," Merkel said.

The warning on the bailout fund announced Tuesday follows S&P's notice late Monday that it may cut the credit rating of 15 eurozone countries, including Germany's, because the region's financial crisis is worsening without any imminent fix.

S&P said there was a 50% chance that the countries' ratings it put on review would be downgraded. And in a separate statement, it said it could downgrade the AAA long-term credit rating for the European Financial Stability Facility, the official name for the bailout fund, by one or two notches. It is now officially on S&P's "CreditWatch with negative implications."

Lower credit ratings mean those countries would have to pay higher interest on their loans, adding to Europe's debt woes. A major slowdown in Europe could depress the economy and stock prices in the U.S.

AAA-rated Germany, the Netherlands, Austria, Finland and Luxembourg could see their ratings cut one notch; ratings on the remaining 10, including AAA-rated France, could fall as much as two notches. Cyprus is already on credit review, and Greece's debt has a high-risk rating.

S&P listed five reasons for its warning:

•Borrowers' increasing difficulties getting loans in the eurozone. European banks are trying to shore up their balance sheets, which means they have less money to lend.

Non-European lenders, such as U.S. money market funds, have become worried about getting repaid on their loans, and slowed down lending, as well. Fewer loans mean slower economic growth in Europe.

•Markedly higher yields on some eurozone bonds, even on some issued by AAA-rated countries. Investors demand higher yields when they think the risk of default is increasing. As those yields rise, it becomes harder for debt-strapped European countries to pay interest.

•Disagreement among policymakers about how to resolve the European debt crisis. If the Europeans don't come to an agreement, countries might leave the eurozone, crippling the value of the euro, the pan-European currency. "That would be devastating for the global economy," says Kathleen Gaffney, co-manager of Loomis Sayles Bond Fund.

•High debt levels in governments and households in the eurozone. Greece has defaulted on some of its government debt, paying 50 cents on the dollar. Portugal is another likely default candidate. Debt burdens become more onerous as interest rates rise and economies slow.

•Rising risks of recession in Europe.

S&P says one solution would be greater budgetary oversight of eurozone members, as well as greater pooling of resources.

"It could be costly for Germany," says Gaffney. Not only would Germany have to pay more interest on its loan, it could have to pay more to help bailout troubled eurozone members, such as Greece and Portugal.

The other members of the eurozone are Belgium, Estonia, Ireland, Italy, Malta, Slovakia, Slovenia and Spain.

S&P said it would try to conclude its credit review as soon as possible after the European Union summit.

Its action increases the pressure on EU leaders to strike a deal that raises investors' confidence in eurozone nations' bonds and governments' ability to rein in deficit spending.

"This is going to take them to the decision point much sooner," says TCW chief Global Strategist Komal Sri-Kumar. " S&P has closed off some avenues to eurozone countries. They can't kick the can down the road."