While financial markets appeared to take Standard & Poor's warning on the likelihood of a Greek default being called largely in their stride, the reaction to Moody's downgrade of Portugal was less sanguine.Early last week, Moody's lowered its long-term rating four notches to Ba2, putting the rating well into junk territory. Moody's also left the outlook on the rating, at negative.The move forced many investment-grade only investors to dump their holdings of Portuguese bonds, even though Fitch and S&P still have investment grade ratings assigned to the country, albeit both are at BBB-. However, it was Moody's rationale for the downgrade that really spooked investors.Moody's said there was a growing risk that Portugal would need a second bail-out and that private sector investors would be required to share the pain. Following the announcement, Markit's iTraxx SovX Western Europe index moved to its widest level, at 250 basis points, and spreads on credit default swaps over Greek Government debt spreads reached a record level, of 2150 bps.   It is perhaps ironic that around the same time the German Chancellor, Angela Merkel, announced she would no longer be paying any attention to the views of the ratings agencies. This was said in the context of any determination by the latter that a Greek default has occurred as a result of a debt restructuring.Merkel will be guided by the views of the IMF, the European Central Bank and the EC. It is likely that many other EU leaders will share her view and ignore the prognostications of the ratings agencies.Indeed, this view was reinforced by the response of other leaders to Moody's downgrade of Portugal. The German Finance Minister, Wolfgang Schauble, said there was no justification for the four-notch downgrade and that the oligopoly of the ratings agencies must be broken. The director of the UN Office for World Trade and Development, Heiner Flassbeck, went further, stating that the CRAs should be dissolved or at least banned from rating countries.However, the markets' response to Moody's downgrade of Portugal suggests the markets have now come to their own view that the much-feared contagion of sovereign failure is happening anyway. It no longer matters whether Greece has "defaulted" or not.In this context, the markets' view is that a practical default has already occurred and political posturing is irrelevant. The focus now is on how much pain investors are going to have to accept as the European sovereign debt crisis rolls on.The focus on investor pain took spreads on the iTraxx SovX Western Europe index beyond 250 bps on Thursday, and Greek CDS spreads reached a new record, of 2200bps. Moreover, contagion fears took spreads on Portugal sovereign risk CDS to a new record of 1000bps; a new record was set for Ireland, at 890bps; while Italy and Spain were the two most actively traded names in the market last week.Investor nerves calmed somewhat later on, with the Spanish Government successfully auctioning €3.0 billion of three- and five-year bonds. Robust investor demand saw the bonds sold