Fitch, a leading credit ratings agency, has downgraded Greece a notch to a CCC "vulnerable to default" rating, citing the heightened risk that the country may leave the Eurozone.
The failure by Greek politicians to form a government - leading to a caretaker administration taking office on Thursday - underscores a lack of public and political support for an austerity programme, Fitch said in a statement, explaining the cut from its B- status.
Should new elections fail to result in a mandate for continued austerity measures, a Greek exit from the monetary union would be "probable", Fitch said.
"A Greek exit would likely result in widespread default on private sector, as well as sovereign euro-denominated obligations, despite a moderate sovereign debt service burden following the restructuring of Greek government bonds in March," the statement said.
It comes after the European Central Bank (ECB) stopped offering liquidity to some Greek banks it did not consider solvent.
Fitch had previously lifted Greece out of default in March, assigning the country a speculative B- rating after a debt swap cut Athens' debt mountain by about 100 billion euros, or close to a third.
Two other ratings agencies, Moody's Investors Service and Standard & Poor's rate Greece a C and CCC respectively.
The IMF, which, along with the EU, is all that stands between Greece and a disorderly default and eurozone exit, has warned that no new funds would be released from the latest 240-billion euro ($305bn) bailout if progress on pledged reforms and tough austerity measures falters.
A caretaker government has now taken charge in Athens, in order to organise the country's second election in six weeks, after an inconclusive May 6 vote led to heightened fears over Greece's possible euro exit and the worsening financial situation in other European countries - particularly Spain and Italy.
The election left Greece in limbo and the new poll scheduled for June 17 offers no guarantee of a viable government able to implement an EU-IMF bailout which has divided the country.
Spanish banks downgraded
Moody's ratings agency has, meanwhile, cut the long-term debt and deposit ratings of 16 Spanish banks, including Banco Santander, the eurozone's largest, saying the government's ability to support some banks had weakened.
Spain's banks, saddled with bad loans after a property boom collapsed in 2008, lie at the heart of the eurozone crisis - as markets fear any major rescue would strain Madrid's already stretched finances, and possibly require an international bailout.
Moody's cut the rating of BBVA, Spain's second largest lender, as well as Santander, even though both are generally regarded as sound - unlike some of their smaller peers.
Those risks were underscored in Madrid, where the national statistics institute INE said the fourth biggest eurozone economy had contracted by 0.3 per cent in the first quarter of 2012.
That was the same decline seen in the closing three months of 2011, and confirmed that Spain was officially in recession, defined as two straight quarters of economic contraction.
Spain's borrowing costs have also shot up.
A newspaper reported a large outflow of deposits from Bankia, but the government said it had taken a fundamental step to strengthen Spain's credibility by agreeing large budget cuts with the country's free-spending regions.
Last week, the Spanish government effectively took over Bankia, the country's fourth-biggest bank, to salvage its balance sheet, reportedly saddled with losses.
It also approved measures forcing banks to set aside a new 30bn euro ($39bn) financial cushion, on top of 54bn euros ordered in February as insurance against bad loans on property.
Italy, the third biggest eurozone economy, is also in recession, while number two France has only narrowly escaped a similar fate. Only Germany has reported positive growth.
European stock markets were rocked by the heightened tension, and fell in afternoon trading, with banking issues taking some of the heaviest losses.
London's benchmark FTSE 100 index fell 1.24 per cent, while Frankfurt's DAX 30 dropped 1.18 per cent, Paris's CAC 40 fell 1.20 and Milan's FTSE-Mib tumbled 1.46 per cent.
Europe's single currency nosedived to a new four-month low at $1.2667 before recovering some ground.