Moody’s Investor Service warns that the continued rapid escalation of the euro area sovereign and banking credit crisis is threatening the credit standing of all European sovereigns.

Without policy measures that stabilize market conditions over the short term, or those conditions stabilizing for any other reason, credit risk will continue to rise, the rating agency says in a new report. “In terms of the policy framework, the euro area is approaching a junction, leading either to closer integration or greater fragmentation,” it says.

Moody’s central scenario remains that the euro area will be preserved without further widespread defaults, but even this ‘positive’ scenario carries very negative rating implications in the interim period, it warns. The rating agency notes that the political impetus to implement an effective resolution plan may only emerge after a series of shocks, which may lead to more countries losing access to market funding for a sustained period and requiring a support program. This would very likely cause those countries’ ratings to be downgraded to speculative grade in view of the solvency tests that would likely be required and the burden-sharing that might be imposed if (as is likely) support were to be needed for a sustained period.

However, over the past few weeks, the likelihood of even more negative scenarios has risen, Moody’s says. This reflects, among other factors, the political uncertainties in Greece and Italy, uncertainty around the final haircut imposed on holders of Greek debt, the emphasis in the recent Euro Summit statement on the conditional nature of the existing support programs and the further worsening of the economic outlook across the euro area.

It says that possible alternative outcomes fall into two broad categories: those involving one or more defaults by euro area countries; and those additionally involving exits from the euro area.

Moody’s says the probability of multiple defaults by euro area countries is no longer negligible, and, the longer the liquidity crisis continues, the more rapidly the probability of defaults will continue to rise.

A series of defaults would also significantly increase the likelihood of one or more members not simply defaulting, but also leaving the euro area, Moody’s says. It believes that any multiple-exit scenario would also have negative repercussions for the credit standing of all euro area and EU sovereigns.

The situation is fluid and fast-moving, Moody’s notes. It says policymakers are likely to respond to the escalating risks with new measures, and the credit implications of those measures will require careful consideration. In the meantime, it says that new shocks to financing conditions are likely to lead to selective rating changes. More broadly, in the absence stabilizing credit market conditions, the point is likely to be reached where the overall architecture of Moody’s ratings within the euro area, and possibly elsewhere within the EU, will need to be revisited, it says. Moody’s expects to complete such a repositioning during the first quarter of 2012.