Europe just can't catch a break these days. While French Fitch naturally came out earlier with a AAA rating and a stable outlook, it is Moody's, which has yet to follow through in S&P's footsteps 14 months later and tell the truth about America's AAA rating, that moments ago spoiled the ESM "inauguration" party by branding it AAA, but with a Negative outlook. So much for the most 'supersecure' CDO on earth: looks like we are not the only ones to assign comical value to the ESM's €80 billion first loss "Paid-in" tranche. Because that 12% in buffered protection can disappear very quick if and when the central planners lose control.
Moody's assigns Aaa/Prime-1 rating to European Stability Mechanism (ESM); negative outlook
First-time rating assignment
Frankfurt am Main, October 08, 2012 -- Moody's Investors Service has today assigned a long-term issuer rating of Aaa and a short-term issuer rating of Prime-1 to the European Stability Mechanism (ESM). The outlook is negative.
The Aaa/Prime-1 ratings are based on (i) the ESM's anticipated low leverage, (ii) the creditworthiness of the ESM's members which are also the euro area member states, (iii) the sound liquidity and capital management policy with an Early Warning System (EWS) which ensures that funds will be available on time, and (iv) the ESM's preferred creditor status. The ESM's purpose is to provide an inter-governmental support mechanism which extends financial assistance to members that are either unable to access the capital markets, or able to do so only at very high interest rates.
The first key rating factor underlying Moody's decision to assign a Aaa rating to the ESM relates to its anticipated low leverage. The ESM has a lending capacity (both loans extended to and purchases of securities issued by supported member states) of EUR500 billion and subscribed capital of EUR700 billion (consisting of EUR80 billion of paid-in capital and EUR620 billion of callable capital). If the ESM's capital is reduced (e.g., due to losses resulting from a borrower default), the leverage ratio -- defined as lending capacity/subscribed capital which must not exceed 71% -- would automatically limit the lending capacity and thereby stabilise the structure of the ESM funding. In such a scenario, loans under existing programmes would continue to be disbursed, but any new lending commitments, which would surpass the lending capacity, would require a simultaneous increase in the ESM's capital.
The second key rating factor underpinning the Aaa/P-1 ratings is that the ESM's shareholders are the euro area's member states, which provide capital to the ESM according to the same capital key that is applied to the European Central Bank (ECB). The ESM therefore benefits from the very high credit quality of its shareholders and the very high likelihood that they will be able to comply with their capital-related obligations. The current capital key-weighted median rating is Aaa, with the two main member states in terms of their capital contribution, Germany and France, both holding Aaa ratings.
The third key rating factor is the ESM's strong liquidity and capital management policy. In particular, the policy aims to ensure that all payments over the next 12 months are fully covered by the ESM's own liquidity reserves and callable capital to be contributed by Aaa-rated shareholders. An additional credit-enhancing feature is the ESM's Early Warning System (EWS) which, by providing an assessment of borrowers'
repayment capacity well in advance of the repayment date, ensures that capital calls can be made and implemented well in advance of any payment shortfall. The ESM Treaty places a legal obligation on the ESM's Managing Director to call capital if needed, without requiring approval by the Board of Governors or the Board of Directors. With respect to its capital management policy, the ESM invests in liquid Aaa-rated instruments, mainly government securities or equivalent.
The fourth key rating factor is the ESM's preferred creditor status that is junior only to that of the International Monetary Fund (IMF). This status differentiates the ESM from its predecessor entity, the European Financial Stability Facility (EFSF), which ranks pari-passu with senior unsecured bondholders.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook on the ESM's Aaa rating reflects the negative outlooks on all but one of its Aaa-rated member states and guarantors. The Aaa-rated member countries that currently have a negative outlook include some that have significant contribution keys, such as Germany (which holds a 27.1% share in the subscribed capital), France (20.4%) and the Netherlands (5.7%). The only Aaa-rated ESM member that has a stable rating outlook is Finland, whose contribution key is 1.8%.
WHAT COULD MOVE THE RATING DOWN
Although the ESM compares favourably to other Aaa-rated Multilateral Development Banks (MDBs) in terms of members creditworthiness, there are several key differences in how the ESM's own creditworthiness could be weakened:
1.) A deterioration in the creditworthiness of the euro area member states (as reflected by a change in Moody's ratings for these states) would weigh on the combined ability to provide support, and consequently have a negative effect on the creditworthiness of the ESM. In light of the correlation of euro area member states' creditworthiness, the ESM is more susceptible to movements in the creditworthiness of its individual members than are many other MDBs, as reflected by the sensitivity of the ESM's rating to changes in the ratings of Aaa countries with large ESM contribution keys, i.e. Germany, France and the Netherlands.
2.) A weakening in the political commitment among euro area member states to the ESM could have negative rating implications. The ESM's policy mandate is related to the preservation of the euro area and is therefore more narrowly defined compared to other MDBs. This could potentially affect the willingness to offer support in a scenario that includes a euro area break-up, although this is not currently Moody's central assumption.
3.) The ESM's asset side points to significant correlation risks, which weaken the intrinsic strength of the ESM and make it potentially more dependent on members' support. By comparison, MDBs usually have a relatively diversified asset structure.
4.) Although the ESM ensures that all payments due over the next 12 months are fully covered by its own liquidity reserves and by callable capital to be contributed by Aaa-rated shareholders, the inclusion of callable capital in the calculation separates the ESM from other MDBs, which often have one year of coverage based only on their own liquidity reserves. This reinforces the correlation of the ESM's rating with the rating of its largest Aaa contributors.
5.) Since the ESM's Aaa rating is based on the assumption of superior financial-management capabilities, transition/downgrade risks could also arise from a potential erosion of those capabilities. An inappropriate skill transfer or skill acquisition would therefore adversely affect the ESM's governance and risk management practice.
Conversely, Moody's would consider moving the outlook for the ESM's ratings to stable if the rating agency decided to change to stable the outlooks on the ratings of those Aaa member states with key contributions to the ESM's capital.