Ireland, home of Guinness beer and the band U2, now brings another export to the market: the continued sovereign debt crisis. As the European Union continues to grapple with its credit crisis, Ireland has recently been thrust right into the forefront of this fight, amid sovereign credit downgrades from both Moody's and Standard & Poor's. While the downgrades will mean higher borrowing costs for the Irish government, they also have a large effect on the nation's banking industry.

Known as one of Europe's financial trouble spots, Ireland's banks have been in a heap of trouble ever since the global recession began. In an attempt to revive its banking sector from its own housing bubble, the Irish government created a "bad bank." This bank, called the National Asset Management Agency, has been purchasing the toxic debt of Ireland's banks. While this effort has assisted banks such as Allied Irish Banks (NYSE: AIB) and The Bank of Ireland (NYSE: IRE) in getting debt off its books, it has also ironically turned out to inflict further hardship on these banks. Ireland's credit rating has been downgraded specifically because of NAMA.

Because of NAMA's recent support of Anglo Irish Bank Corp., Standard & Poor's lowered Ireland's credit rating from "AA" to "AA-" as well as affirmed a negative outlook on the country, meaning there is a possibility of further downgrades in the near future. This downgrade likely means losses for both Allied Irish Banks and The Bank of Ireland, since both hold large amounts of Ireland's debt. Also, NAMA will now have more difficulty raising funds to purchase toxic assets to revitalize the banks. Investors will be more hesitant to purchase Ireland's lower-quality bonds, and those that do will demand a higher yield. As if that weren't bad enough, the continued deterioration of sovereign credit throughout Europe means that the banks themselves will also likely face higher borrowing costs.

Until Ireland can straighten out its finances, investors should stay far away from Allied Irish Banks and The Bank of Ireland. Instead, consider Canadian banks such as Royal Bank of Canada (NYSE: RY) or Bank of Nova Scotia (NYSE: BNS) as the banking system in Canada is in much better shape. Irish banks are likely in for a long struggle to recover from the excesses of the housing bubble, and now even the government in Ireland may now be in financial danger.

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