The European Financial Stability Facility (EFSF) has always been at pains to emphasise that its creditworthiness is based on the value of the guarantees provided by its AAA constituents.
Speaking exclusively to Euromoney in May, EFSF CFO Christophe Frankel stated: “The EFSF structure is now very well understood. Investors understand that the EFSF’s quality is based only on AAA countries.”
There used to be six of those – but as far as S&P is concerned, there are now just four, one of which is tiny Luxembourg, which contributes just 0.27% of the EFSF guarantees.
When S&P placed the EFSF on negative credit watch on December 5, it stated that “were we to lower one or more of the current AAA ratings on EFSF’s guarantor members, all else being equal we would lower the issuer and issue ratings on the EFSF to the lowest sovereign rating on members currently rated AAA”.
Given that Austria and France are now AA plus, that means the EFSF is too, according to the agency.
With the downgrade of the EFSF by S&P on January 16, the question is whether Moody’s and Fitch will downgrade too. That depends on their view of France, which contributes 21.83% of the facility's guarantees.
Moody’s has the country on a stable outlook but will review and update this during the first quarter of this year. Fitch has France on a negative outlook, which Rabobank analysts believe means there is a 61% chance the agency will downgrade by August 26.
However, this does not spell immediate disaster for the fund.
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“This points to more peripheral tension as the safety net becomes weaker and will drive efforts to bring the ESM forward in order to take the EFSF out of the picture altogether,” - Richard McGuire, Rabobank |
"S&P is only one of three agencies," says Richard McGuire, senior fixed income strategist at Rabobank in London. "Logically one would expect that a downgrade by two agencies would be needed for the EFSF to lose its AAA status."
A sub-AAA EFSF has three options: increase the credit enhancement provided by the remaining AAA-rated guarantors; lend less; or simply issue as a AA and pay more. Option one is extremely unlikely to be agreed upon, particularly by Finland, and option three will increase the cost of borrowing for sovereigns such as Portugal, which the EFSF is supposed to be helping.
As for option two, the guarantees provided by Germany, Finland, Luxembourg and the Netherlands give the fund an effective lending capacity of €271.4 billion – down from the already inadequate €440 billion that it has been trying so hard to leverage.
“Private sector involvement in the EFSF’s plans to lever itself was already a somewhat distant prospect,” says McGuire. “S&P’s actions make the overall EFSF rating more tenuous, and limits what the already slim degree of private sector participation would have been. The attractiveness of credit protection notes will also diminish as the wrap is now less robust.”
It is difficult to see how the downgrades announced by S&P on Saturday do not spell the end of the EFSF. Its mandate was already close to impossible as a AAA entity; as the foundations of its creditworthiness are stripped away, it becomes even more so.
“This points to more peripheral tension as the safety net becomes weaker and will drive efforts to bring the ESM forward in order to take the EFSF out of the picture altogether,” says McGuire.
But the European Stability Mechanism (ESM), which was originally due to take over from the EFSF in 2013 – but will now likely be ushered in July this year – will be hit by the downgrades too. It is more likely to achieve a AAA rating than the EFSF, as its rating will be based on paid-up capital rather than reliance on guarantees.
However, with no further increase to the current callable capital levels, the lending capacity of the ESM would decline by €200 billion, following S&P’s decision to downgrade France and Austria, according to Jacques Cailloux, strategist at RBS.
“To maintain the current lending capacity and its AAA, member countries would need to double their level of callable capital into the ESM compared to the current commitment,” he stated shortly after the downgrades were announced. “Should euro-area policymakers want to double the lending capacity of the ESM from pre-downgrade times – while maintaining its AAA – then the ESM would need a callable capital of almost 30% of euro-area GDP.”
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