Hidden among the detritus of last night's MF headlines and JPY Azumification, Moody's released their Weekly Credit Outlook. The report was rather unsurprisingly (given our perspective on the lack of real news last week) negative on the Euro Summit implications noting that while some positives remain, the negatives at a grossed-up level seem to outweigh the market's exuberance. In most scenarios they see the impact as neutral (for Ireland and Portugal, European banks and Insurers, and the EFSF itself) but they are most concerned at the impact the 'plan' will have on AAA-rated euro are countries. We can only leave it to the market to decide how self-referencing CDS should be priced.
From Moody's Credit Market Weekly:
Key Credit Implications of Euro Area Summit
Last Thursday, European policymakers issued a communiqué announcing a series of additional measures aimed at addressing the formidable challenges facing the euro area. The following are the key credit takeaways we draw from the statement:
Aaa-rated euro area countries: neutral to negative. These countries face increased exposure from European Financial Stability Facility (EFSF) first-loss guarantees potentially being called. Also, the prospect of additional mutual support implies a greater risk to creditors of the countries that ultimately provide support. However, if the measures are successful, they could more than offset this additional risk by improving overall credit conditions.
Greece: negative for current creditors, positive for future debt sustainability. Private holders of Greek sovereign bonds now face a default in the form of debt write-downs of 50%, although they may benefit in the future from improved sovereign debt sustainability. It is still uncertain whether creditors will face additional write-downs in the event of a re-default.
Ireland and Portugal: neutral. Overall, creditors of countries currently receiving support and other countries that may suffer from limited market access in the future benefit from the increased resources that the EFSF will have available. However, while the announcement restates the 21 July language on the private-sector involvement (PSI) solution for Greece as being unique, it also re-emphasizes the conditionality of existing support programmes.
Italy and Spain: neutral. It is not clear if the enhanced tools proposed for the EFSF will be effective at easing the market-funding challenges facing the two countries. The country-specific measures previously announced for both are positive, but considerable risks remain in successfully implementing the fiscal and structural reform programs.
European banks: marginally positive. Capital strengthening and funding guarantees benefit creditors and may help improve market conditions, at least temporarily. However, they will not, in our view, solve the underlying problem of sovereign debt concerns.
European insurers: neutral to mildly positive. The increased Greek debt write-down does not materially affect insurers.1 To the extent that the European Union’s (EU) decisions help stabilize the credit quality of sovereigns and banks, insurers benefit.
European Financial Stability Facility: neutral. Neither of the two options for expansion/leverage of the EFSF involves a change in the way that member states guarantee notes issued by EFSF and, therefore, neither affects the EFSF’s creditworthiness.
They go on to discuss the negative implications for bank and sovereign creditors:
Sovereign problems remain. While these measures may alleviate investor concerns temporarily, the provision of guarantees and capital by euro area sovereigns will not alleviate long-term pressures and return markets to anything approaching normalcy as long as the underlying concerns over sovereign credit risk remain.
Risks on path to higher capital. We see heightened implementation risk to the announced capital strengthening targets that the EU is mandating that banks reach by 30 June 2012. Those risks include the following:
- Some banks will struggle to raise capital in private markets or via lower dividends, reduced bonus payments and other cost cutting measures. The capacity of such banks to bolster capital through balance sheet restructuring and debt-to-equity conversions will also likely be limited. As such, we expect that at least a portion of the additional capital required will come from governments. This would further pressure already-stretched sovereign balance sheets or dilute mutual resources such as the EFSF, unless any provided capital is repaid fully and timely, which is uncertain ex ante.
- It is likely that banks will try to reduce their lending to shrink their asset base in order to meet at least part of their capital targets. Any such deleveraging risks damaging economic growth, which would exacerbate banks’ asset quality challenges, and, in turn, would press banks to deleverage even more, possibly creating a vicious cycle.
Greek losses are unclear. Greek private-sector creditors will lose at least 50% of their investment. They may still lose more.
Elevated risk for junior creditors. Restructuring and debt-to-equity swaps may significantly increase risk for junior bondholders.
Hedge ineffectiveness of sovereign credit default swaps. The push towards a “voluntary” restructuring of Greek government debt looks set to result in the avoidance of a credit event as defined by the International Swaps and Derivatives Association. The likely perspective of bondholders facing a 50% haircut on their sovereign exposure without the credit protection becoming effective will raise questions about the hedge effectiveness of credit default swaps for sovereign debt and thus increase banks’ net exposure to European sovereigns
Perhaps the most important of the charts and tables within the report is the following - showing the non-AAA Sovereign Exposure among European banking systems.
Moody's scenario analysis shows that while EBA stress tests may require
specific capital to be raised, from a more realistic capital
perspective, the numbers could be significantly higher.
It is very evident that Moody's has a far less sanguine bias to all of the financial engineering and self-referential subordination and leverage - making one wonder just how long France can hold that AAA rating - "damned if they do and damned if they don't" seems the best description for now.