Standard & Poor's revised the outlook for Iceland's long-term credit rating to negative from stable on Friday, advising the government against pursuing a plan for massive mortgage relief.
The credit rating agency said its move was based on an estimate that there was "at least a one-in-three chance" that it could lower Iceland's ratings within the next two years.
"The outlook revision reflects our view that we could lower the ratings if household debt forgiveness -- as promised by the new government in its coalition agreement -- substantially worsens Iceland's fiscal ratios or weakens our assessment of the effectiveness and predictability of policymaking," S&P said in a statement.
"The contemplated debt write-offs, if funded through a haircut imposed on existing creditors to the defaulted Icelandic banks (the old banks), could also damage foreign investors' confidence in Iceland and further delay the lifting of capital controls."
Mortgage debt was a major theme in April elections on Iceland.
The vote led to the removal of a leftist coalition amid voter discontent over austerity measures, imposed after the small island economy was battered by crisis toward the end of the last decade.
The new government has promised measures to ease the burden on mortgage holders struggling with inflation-linked debt, and a concrete proposal is expected to be announced in November.
S&P said details of the write-down remained to be seen, but it estimated it could exceed 10 percent of Iceland's current gross domestic product or, the agency added, "possibly much more."
S&P said: "We could consider lowering the rating if we reassess the strength of Iceland's policy environment and institutional framework as a result of this policy shift."
It also said: "The ratings could stabilise at the current level if we see that the scope of debt relief is limited, the cost to the state is contained, and the mode of financing does not, in our view, deter investment into the Icelandic economy."