While some have dismissed Portugal as irrelevant, this downgrade should not be taken lightly. Although it’s true that Portugal’s economy is small, even smaller than that of Greece, its public debt — and more importantly its private debt — sit on the books of nearly every major European banking institution. At the same time, much of its debt is secured by credit insurance instruments issued by several U.S. banks, exposing them to losses too. For now, the European Central Bank says it will continue to support Portugal by repurchasing its debt, but this latest downgrade has made it much tougher for the country to try and dig itself out of its debt hole.

For starters, it should be said right off the bat that few expect Portugal to default on its debt anytime soon. Unlike with Greece, where a default last month seemed imminent, Portugal is seen to be in a potential default situation sometime in 2013. That’s because it just received a big bailout loan from the European Union and the International Monetary Fund to help service its debts. Under the terms of the deal hammered out in May, Portugal will receive 78 billion euros over time, which, like Greece and its 110 billion euro loan approved last year, is contingent on the country’s ability to meet certain debt reduction targets.

Greece’s main problem is that it has failed to make any meaningful progress in reducing its debt and getting its economy back on track. Portugal, on the other hand, has made great strides in getting its house in order. The terms of its loan specify that the country should cut public spending by 7% while holding revenues flat. Portugal is doing pretty good so far as revenues are up 9% from last year while government expenditures are down 4%. Its central government debt is now 69% smaller than where it was last year. UBS projects that Portugal should therefore “comfortably” achieve its 5.9% deficit target agreed to with the IMF as part of its loan.

Compare that to Greece, where revenues are down 5% while central government debt is up 13% from where it was last year and you begin to see why the markets have been more concerned with a default out of Athens as opposed to one from Lisbon.

Portugal’s relative success in combating its debt troubles is why the market was thrown off guard by the downgrade this week. Everything seems to be on track for the country and it just received its first installment of its loan from the IMF at the end of June. A new conservative government is expected to push through a large austerity package in the coming months while it ramps up assets sales to help meet the future debt targets.

What happens in Greece…

But Moody’s is still concerned that Portugal will end up like Greece when all is said and done. The ratings agency does not have faith in the new Portuguese government’s ability to cut spending fast enough to service its debt. It’s also concerned about talk that Europe may force private investors in Greek sovereign debt to take a haircut on their investment. Analysts believe that talk of such an action would ultimately discourage further private investment in Portuguese debt, therefore making the country dependent on the European Central Bank to buy any new debt it needs to issue in the future.

It’s unclear if the Portuguese will be successful in slashing their way to fiscal normality. In Greece, the passage of harsh austerity measures last year caused its GDP to shrink as it was forced to lay off thousands of people from its bloated public sector. Portugal will face similar troubles as it starts to make cuts. And thanks to Moody’s downgrade, it will now have to pay more to issue new debt. Many investment firms are not allowed to invest in junk bonds, therefore forcing Portugal to raise yields to attract speculative investors.

At first glance it seems like the market is overreacting to Portugal’s debt woes. But take a closer look into the country’s financials, and it’s clear why Moody’s is concerned. The nation’s debt to GDP ratio stands at around 93%, which is far less than Greece at 140%. But Portugal’s problem is its private debt load, which is a whopping 230% to GDP, thanks in large part to its citizenry borrowing billions of euros to pay for their new upgraded lifestyle.

Credit Suisse estimates that a third of the cost of getting rid of the excess private debt will eventually be imposed on the government, pushing the nation’s debt to GDP ratio up to 134% by 2014. To pay off that debt, the government will need to issue even more debt, which is now much harder to do. That would be fine if the country’s economy was growing, but it grew by just 0.5% per year over the last decade and is now expected to slow once the new government initiates all those austerity measures.

Portugal will be watching what happens in Greece very closely. If the Europeans force private investors to take a haircut on their debt, Portugal will surely want the same. Credit Suisse estimates that Portugal will probably need a 30% cut on its government debts, which is larger than most, thanks to all that private debt due to fall on its books. This is like moral hazard on a monumental scale as Ireland, Spain and possibly even Italy would likely request a haircut on their debt. The cumulative effect could crush Europe’s banking sector.

Foreign bank holdings

So how bad could it be? As of the third quarter of 2010, Portugal had around $321.8 billion worth of private and public debt held by foreign institutions, more than Greece, which had $277.9 billion, according to the Bank of International Settlements. The bulk of Portugal’s exposure is from eurozone investors to the tune of $232.6 billion. Therefore a 30% haircut on Portugal’s total debt would amount to a hit to European investors to the tune of around $70 billion.

A large chunk of that debt is held by banks and investors in France and Germany, which had direct exposures to Portuguese debt at the end of 2010 of around $27 billion and $36 billion, respectively. But that’s not all the exposure they have. Banks in those countries sold other investors insurance on Portuguese debt through credit default swaps, which would pay out if the country ever defaulted on their debt. Adding in the CDS, the net exposure to Portuguese debt jumps to $32.3 billion for France and $50.2 billion for Germany.

The swaps play a key role in U.S. exposure. It has just $5.2 billion in direct exposure to Portuguese debt, but when you add in the CDS, the total net U.S. exposure pops to $46.5 billion, putting it roughly on par with total German exposure.

These are quite large numbers coming from such a small country. But those numbers pale in comparison to a possible Irish default. Ireland has more foreign debt outstanding than both Greece and Portugal, combined, with a mind-blowing $813.7 billion. That means that foreign investors could be facing losses of around $424 billion if all three countries have their collective private and public debt loads slashed by 30%.

That’s nearly half a trillion dollars, and we haven’t even started to talk about Spain or Italy yet. Their foreign debt loads are multiples of Portugal, Greece and Ireland as they both have very active debt markets.

So while Portugal is a small country with just 11 million people, this downgrade has set in motion a series of events that have European leaders understandably on edge. Some have called for credit ratings to be totally suspended on nations receiving bailout funds while they get their house in order. But a lack of a credit rating won’t make them more attractive to investors. Eventually, someone has to take a hit on all this bad debt floating around Europe and investors are scrambling to get as far away from the explosion as possible.