Greece hit the fan in a big way overnight, dragging markets around the world lower and setting up the possibility of a crunch.

Ratings agency Standard and Poor’s triggered the latest eruption of fear by slashing Greek debt to junk status, and it also cut Portugal’s rating by two notches; moves that came as a complete surprise. Markets fell around the world with Europe seeing the biggest sell of 2010 so far, and oil and copper and other commodities dropped as speculators abandoned risky investments for the safe heaven of US government debt. That in turn drove the euro lower and the US dollar higher.

S&P cut its rating of Greek government debt by a full three notches to BB-plus, the first level of speculative of junk status. The outlook is negative, meaning Greece could be downgraded again. The rating is three to four notches under what Moody’s and Fitch suggest at the moment. One of those will follow soon. The downgrade put Greece on par with Romania and below Kazakhstan, Hungary and Iceland, which all but collapsed after its banks imploded at the start of the global financial crunch in 2007.

But in the US, the news had to compete with the latest act in the Goldman Sachs (AKA Vampire Squid) passion play in Washington as seven executives testified and fought an aggressive Senate investigations committee probe of the bank’s activities and morals.

The Washington theatrics helped add to the rising sense of fear from Monday, which saw steep rises in yields on two-year and 10-year Greek debt, which in turn hit yields on Portuguese, Italian and Spanish debt.

To try and stop the rot the IMF suggested offering Greece another €10 billion on top of the €10 billion already on offer and the €30 billion from the EU, if Germany agrees. But that puts Greece at the limit of the €25 billion the fund can lend to it.

Trade in Greek bonds has almost halted as buy/sell spreads widened to extravagant levels. The yield on two-year Greek government bonds peaked at just under 19% in trading overnight, an impossibly high level and one that signals almost certain default. They ended just shy of an almost hard to believe 15%, the highest close ever. And the 10-year bond yield hit 9.77%. Two-year Portuguese government bond yields jumped to 5.7% from 4.16% on Monday after the S&P announcement. US government 10 year bond yields fell sharply to 3.68% as investors abandoned riskier assets and headed for safety.

As a result, Greece is effectively locked out of the markets and can’t raise money, meaning it will have to be given about €8.5 billion in loan money by May 19 if it is to meet a big debt falling due then. Portugal is heading that way at increasing cost.

Greece’s downgrade crunched the US sharemarket, halting the rally in its track and sending it down more than 200 points (1.9%) and to below 11,000 points on the Dow. In London the market lost 2.6%. In Athens, the market fell 6% but had closed before the rating downgrades were released, meaning there’s another big fall ahead tonight. Markets in Ireland and Spain, fell more than 4%, Portugal’s lost over 5% in value. All three countries are said to be “next’ after Greece in attracting market attention because of the high deficits and debts..

Greece’s downgrade was the first time a eurozone member has been rated at junk level since the euro was introduced 11 years ago and, the ratings group sent a big message to the holders of Greece’s estimated €273.3 billion of debt.

In its rating announcement, S&P assigned a recovery rating of “4” to Greece’s debt, indicating it expected an “average” recovery of  30%-50% for holders in the event of a Greek restructuring or default. At worst European banks (with some in the US), would be looking at $US180 billion in losses, before being forced to write-down the value of their holdings of other sovereign debt, plus their holdings of related debt.

The situation wasn’t helped by more outrageous comments from German politicians, especially from Chancellor Angela Merkel’s coalition partner, the Free Democrats, and populist reporting in German papers. It’s as though German politicians are deliberately inflaming the situation, without understanding that should Greece default, then Germany will lose, along with the rest of Europe and possibly the global economy as a whole.

Given the central and scandalous role Germany has played in sinking Greece, it is some how appropriate that its predicament was best summed up by this quote on Reuters from Thomas Mayer, chief economist of Deutsche, Germany’s biggest bank, who overnight said that Greece has entered “a death spiral of government insolvency”. Helped by German intransigence and chauvinism as the government jockeys to advantage in the campaigning for the vital poll in Rhineland North Westphalia on May 9. By the time that is over, Greece could very well have defaulted.