S&P Issues Statement On EFSF, Says "Almost Certain" European Governments Would Support CDO

Tyler Durden's picture

The first kicker in the just released S&P statement on the revised and AAA-rated EFSF is the following: "In our opinion, there is an "almost certain" likelihood that the EFSF's 'AAA' rated member governments would provide timely and sufficient extraordinary support to the EFSF if needed." So, uh, S&P is determining the fate of trillions worth of securities on the basis of a hunch, a whim, if you will. A strong one, but a hunch nonetheless. Swell. And the second kicker:  "If we lowered the ratings on one or more of the 'AAA' rated member guarantors, we would also likely lower the ratings on funding instruments that the EFSF had issued before the date of the downgrade, if the lower ratings on the member guarantor were to lead to less than 100% 'AAA' rated coverage for the relevant EFSF funding instrument." This, in the parlance of our times, is known as a springing downgrade, which sets off the kind of cataclysm that only AIG could achieve once the investing community realized it had a rating-based collateral schedule. So once again the fate of the free world depends on FrAAAnce. Swell2.

From S&P:

Overview

  • Guarantees from eurozone member states (members) continue to be a main factor underpinning the ratings on the European Financial Stability Facility (EFSF).
  • In our opinion, there is an "almost certain" likelihood that the EFSF's 'AAA' rated member governments would provide timely and sufficient extraordinary support to the EFSF if needed.
  • We are therefore affirming our 'AAA' issuer credit rating and assigning a short-term rating of 'A-1+' on the EFSF.
  • The outlook is stable.

Rating Action

On Oct. 28, 2011, Standard & Poor's Ratings Services affirmed the long-term issuer credit rating on the European Financial Stability Facility (EFSF) at 'AAA'. At the same time we assigned a short-term rating of 'A-1+' on the EFSF. The outlook is stable.

Rationale

To assess both the quantitative and qualitative indicators of the EFSF's creditworthiness we apply our criteria, "Principles of Credit Ratings," published Feb. 16, 2011. Guarantees from European Economic and Monetary Union (eurozone) member states (members) continue to be a main factor underpinning the ratings on the EFSF. However, we also recognize that the EFSF has government-related-entity (GRE) characteristics, as outlined below. We see the EFSF as the principal source of emergency financing for its members. Loans are disbursed in tranches to a member experiencing difficult financing conditions, subject to the member's compliance with budgetary and other reforms in conjunction with IMF programs. In the future, fully guaranteed credit enhancements may be provided by the EFSF to member states that agree to implement specific measures, which may not necessarily be part of an IMF program.

In accordance with our criteria for guarantees and GREs, the ratings on the EFSF reflect Standard & Poor's opinion that there is an "almost certain" likelihood that its 'AAA' rated member governments would provide timely and sufficient extraordinary support to EFSF should it require support.Our rating on the EFSF is based on our view of its:

"Critical" role for its member governments. We consider the EFSF to be the cornerstone of the EU's strategy to restore stability to the eurozone sovereign debt market and to preserve confidence in the European financial system. The strategy is to provide conditional financing to member governments that are committed to pursuing a European Commission-backed program of fiscal and structural reforms (usually in conjunction with the European Central Bank and the IMF). In our view, member states will ensure that the EFSF can pay all its debt obligations on time and in full, given their recognition of the EFSF's importance in preserving investor confidence in eurozone sovereigns and eurozone financial sector creditworthiness; and

"Integral" link with its member governments. The EFSF's board of directors comprises senior, mostly ministry–of-finance officials, nominated by EFSF member governments. Unconditional, irrevocable, and timely guarantees from EFSF members rated 'AAA' by Standard & Poor's; or 'guarantees made by 'AAA' rated members plus liquidity reserves invested in 'AAA' rated securities will, in our opinion, cover the EFSF's potential liabilities.

The EFSF was established in mid-2010 by intergovernmental agreement among members. Its purpose is to raise capital-market funding to provide loans to members facing difficulties accessing funding from the markets at sustainable rates.

Initially, the EFSF was limited to extending direct loans to members under individual Loan Facility Agreements. At that time, the rating on EFSF and the securities it issued under its medium term note (MTN) program reflected our view that guarantees made by 'AAA' rated members and liquidity reserves invested in 'AAA' rated securities would cover all of the EFSF's potential liabilities. Each non-borrowing member was to provide a timely, unconditional, irrevocable, and several guarantee of up to 120% of its own share of the bonds issued by the EFSF (the "over-guarantee"). Under this structure, EFSF members pledged a total of €440 billion in guarantees (about 6% of 2011 eurozone GDP), of which about 62% (€255 billion) were guarantees made by 'AAA' rated members. In our view, the face amount of 'AAA' guarantees effectively limited how much the EFSF was likely to borrow to on-lend to eurozone sovereigns.

On June 24, 2011, the EU Heads of State and Government agreed to increase the effective lending capacity of the EFSF to €440 billion through an increase in the maximum-guarantee commitments of member states to €780 billion (about 8% of 2011 eurozone GDP) and a related increase to 165% from 120% in the over-guarantee provided by each non-borrowing member. As Ireland, Greece, and Portugal are "stepping-out" guarantors, the level of maximum guarantees is reduced to €726 billion from €780 billion. We estimate that applying the over-guarantee of 165% to €726 billion gives the EFSF an effective direct-lending capacity of €440 billion. However, as 62% of the €780 billion in guarantee commitments is from 'AAA' rated sovereigns, we expect that the EFSF can borrow up to €452 billion without putting downward pressure on its 'AAA' rating.

The scope of EFSF activity has also broadened as part of a March 11 announcement to the effect that it may, exceptionally, intervene in the debt primary market.

At the eurozone summit held on July 21, 2011, the decision was taken to further widen the EFSF's scope of activity, allowing it to:

    Act on the basis of a precautionary program.
    Recapitalize financial institutions through loans to governments, whether or not they are program countries.
    Intervene in the secondary markets if European Central Bank (ECB; AAA/Stable/A-1+) analysis reveals exceptional financial-markets circumstances and risks to financial stability, and if EFSF members mutually agree to act to avoid contagion.

As a result, the EFSF will have new lending instruments that are designed to enable it to react in a timely manner to members' financing needs. As part of this, it will issue short-term debt under its current €55 billion issuance program. Based on our view of the program's documentation, we expect to be able to assign a 'A-1+' rating to this short-term debt.

These changes to the EFSF are encompassed in the amended EFSF framework approved by all member parliaments as of Oct. 14, 2011. Under the amended structure, EFSF potential issuance of bonds, notes, commercial paper, debt securities, or other financing arrangements (collectively, funding instruments) will be matched solely by guarantees made by 'AAA' rated members.

The requirement for liquidity reserves invested in 'AAA' rated securities will be removed. However, outstanding funding instruments issued before the amended EFSF framework--those relating to the Irish and Portuguese programs--will remain backed by unconditional, irrevocable, and timely guarantees from 'AAA' rated EFSF members and liquidity reserves invested in 'AAA' rated securities.

We consider that EFSF's use of funds it raises in the capital markets does not directly affect our issuer credit rating on EFSF--as long as these funds continue to be backed by guarantees made by 'AAA' rated members (amended framework) or guarantees made by 'AAA' rated members and liquidity reserves invested in 'AAA' rated securities (original framework).

On Oct. 26, 2011, EFSF members agreed to leverage the resources of the EFSF through investments, partly in special purpose vehicles (SPVs), which will provide risk insurance and/or conditional direct financing or investment in member states. We do not expect this will affect the ratings on the EFSF as long as EFSF's liability is limited to its equity-at-risk and not associated with the assets and operations of the SPVs. In our view, the EFSF's borrowing capacity will remain constrained, at €452 billion, by the amount of guarantees made by 'AAA' rated members.

However, if EFSF-funded financial support programs do not improve market confidence in the eurozone, and contagion puts 'AAA' rated members' ratings under pressure, this could indirectly affect EFSF's creditworthiness.

The EFSF has a limited life span and is not expected to enter into new loan agreements after June 2013. The incoming European Stability Mechanism (ESM) may assume the EFSF's prior financial obligations and commitments. We expect any outstanding EFSF funding instrument with interest or principal due after 2013 will remain secured either solely by guarantees made by 'AAA' rated members, under the amended EFSF framework, or guarantees made by 'AAA' rated members and 'AAA/A-1+' rated securities as defined under the original EFSF framework.

Outlook

The stable outlook reflects our view of an "almost certain" likelihood of the EFSF's 'AAA' rated member governments providing timely and sufficient extraordinary support to the entity in the event of financial distress.

Our rating and outlook on EFSF are based on our view of the guarantees on EFSF liabilities that 'AAA' rated members provide, as well as on our opinion of EFSF's critical role for and integral link with its members.

If we lowered the ratings on one or more of the 'AAA' rated member guarantors, we would also likely lower the ratings on funding instruments that the EFSF had issued before the date of the downgrade, if the lower ratings on the member guarantor were to lead to less than 100% 'AAA' rated coverage for the relevant EFSF funding instrument. However, despite the reduction in the number of 'AAA' member guarantors, the ratings on such funding instruments could remain at 'AAA', if we saw that additional credit enhancements were in place to offset the lowering of the sovereign rating, so that coverage that we viewed as commensurate with a 'AAA' rating was maintained.

The same is likely to apply to EFSF funding instruments issued after the downgrade of one or more of the 'AAA' member guarantors. Although full coverage that we viewed as commensurate with a 'AAA' rating could be maintained, the EFSF's lending capacity would be reduced under these circumstances.

We could lower our issuer credit rating on the EFSF if the total of EFSF's liquid 'AAA/A-1+' rated securities and its guarantees made by 'AAA' rated members were to become less than the total of its outstanding funding instruments.

In general, we expect the outlook on EFSF's issuer credit rating to reflect the outlook on the sovereign ratings of its weakest 'AAA' guarantors.