First it Egan-Jones (of course). Then S&P [26]. Now Fitch (which sees the Spanish bank recap burden between €60 and a massive €100 billion!) joins the downgrade party of rating agencies that have Spain at a sub-A rating. Only Moody's is left. What happens when Moody's also cuts Spain from its current cuspy A3 rating to sub-A? Bad things: as we explained on April 30 [27], when everyone has Spain at BBB or less...
If all agencies downgrade Spain to BBB+ or below, the ECB could increase haircuts by 5% on SPGBs
The key aspect in terms of the Spanish downgrade(s) is the ECB's LTRO. If all three rating agencies move Spain to BBB+ or below then under the ECB's current framework it moves into the Step 3 collateral bucket which requires an additional 5% haircut across the maturities. In classifying its risk management buckets, the ECB uses the highest of the ratings to determine an asset's position (unlike the sovereign benchmark indices which use the lowest rating, in general). Fitch and Moodys currently rate Spain at A and A3 respectively, with both having a negative outlook in place leaving only a small downgrade margin before Spain migrates to the lower ECB bucket.
Italy's position is marginally more precarious in that it shares Spain's A3 rating from Moody's but is rated lower at A- by Fitch, and is similarly outlook negative from both agencies. One would hope ECB pragmatism would prevail and move to be more accommodative on its collateral haircut rules on sovereign debt.
The weakness of the eurozone's growth outlook is undermining the efforts of many sovereigns to rein in budget deficits, thereby highlighting the self-defeating nature of the fiscal compact as currently defined. Including the political impact, this has potential to lead to further downgrades
[28]
LTRO funding is not suitable when collateral values are unstable LTRO, like all repo funding, should only have been implemented with quality assets to avoid excessive margin calls. In 2009-10, when the operations were used to good effect, the majority of European sovereign assets were still perceived to be 'risk free'. 5-year SPGBs rallied from 4.95% in mid-2008 to 2.62% in December 2009 and non-performing loans were at roughly half of their current levels. In 2009, despite economic weakness, risk had generally been contained through continued fiscal programs, and with the ECB providing continued cheap funding it was sufficient to allow some normalization. The key difference between then and now is that sovereigns no longer have the ability to utilize the fiscal side. When the ECB announced the twin LTROs at the end of last year the sovereigns were clearly in a different state from 2009.
If the ECB believes in the mandated reforms it should be comfortable with warehousing sovereign risk
If the ECB believes in the currently prescribed course of reforms and their implementation it should have little issue with holding a major sovereign's collateral on its balance sheet. Taking this a step further, the ECB is generally concerned with moral hazard, which along with subordination, is likely also a reason why we have yet to see the SMP program buying bonds recently. But this is a double-edged sword in that it gives investors little confidence in the sovereigns' recovery prospects if the central bank appears to be in internal turmoil and is showing no action besides utilizing measures that are more suited to a strengthening market. One of our common refrains during the crisis is that moral hazard should not frame the reaction function of central banks. Rather, the over-riding and immediate objective of policymakers during a crisis needs to be avoiding non-linear or dual equilibrium risk. This requires aggressive and bold policies to be enacted. Europe's policymakers have notably failed on this front, and, hence, we have a crisis that has entered its third year.
[29]
The ECB’s discomfort is no comfort to investors, eroding confidence
The key question remains in Spain as to who is the marginal buyer of debt beyond the domestic banks and primary dealers. Although the Spanish Treasury has sold a significant amount of its 2012 requirements, as things currently stand the country faces a multi-year funding problem. The extent to which domestic savings filtering through to bond buying is limited given that the general level of savings is likely at its limit. Banks, Santander and BBVA, have also said that they have no more capacity for further sovereign bond purchases given they are at the limit of their risk concentration limits (link [30]), which we think was rather diplomatically put. One risk is that domestic institutions shorten their SPBG holdings and focus more on bills, which would likely be unaffected by any debt restructuring.
We will see a worse situation before any meaningful response is produced by the ECB: QE
Our view is that things will get significantly worse before any meaningful policy response occurs. From the ECB?s perspective this entails pre-announced QE in a size which is commensurate to the problems faced. If the ECB believes in the actions taken by sovereign governments, which it has largely mandated, then its current responsibility is to stabilize sovereign markets in order to facilitate sovereigns' continued financing. The key inhibitor is the deterioration in the political union and the consequent ability to formulate a political response. Absent a proportional policy response, euro breakup remains more probable than possible at this juncture.
Key takeaways for us are:
- the 5% haircut that will force margin calls on the most cash-strapped banks;
- the 10% funding level beyond which the ECB's intervention in the banking system becomes restrictive and self-defeating;
- LTRO funding is not suitable when collateral values are unstable LTRO, like all repo funding, should only have been implemented with quality assets to avoid excessive margin calls;
- greater ECB use defers the point at which a sovereign or bank faces a funding challenge, but accelerates the point at which a return to private market financing is unlikely without external support;
- and finally, the most effective response for Spain would be to de-link sovereigns and their banks, following recent steady accumulation of sovereign debt by peripheral banks, in our view.
* * *
And here is the full Fitch statement:
Fitch Downgrades Spain to 'BBB'; Outlook Negative
Fitch Ratings-London-07 June 2012: Fitch Ratings has downgraded Spain's Long-term foreign and local currency Issuer Default Ratings (IDR) to 'BBB' from 'A'. The Short-term IDR has also been downgraded to 'F2' from 'F1'. The Outlook on the Long-term IDRs is Negative. Fitch has simultaneously affirmed the common Euro Area Country Ceiling for Spain at 'AAA'.
The downgrade of Spain's sovereign ratings by three notches reflects the following factors:
-- The likely fiscal cost of restructuring and recapitalising the Spanish banking sector is now estimated by Fitch to be around EUR60bn (6% of GDP) and as high as EUR100bn (9% of GDP) in a more severe stress scenario compared to Fitch's previous baseline estimate of around EUR30bn (3% of GDP);
-- Gross general government debt (GGGD) is projected by Fitch to peak at 95% of GDP in 2015 assuming a EUR60bn bank recapitalisation, compared to Fitch's forecast at the beginning of the year of 82% by the end of 2013;
-- Spain is forecast to remain in recession through the remainder of this year and 2013 compared to Fitch's previous expectation that the economy would benefit from a mild recovery in 2013;
--Spain's high level of foreign indebtedness has rendered it especially vulnerable to contagion from the ongoing crisis in Greece; and
-- The much reduced financing flexibility of the Spanish government is constraining its ability to intervene decisively in the restructuring of the banking sector and has increased the likelihood of external financial support.
The downgrade follows a series of recent steps taken by Fitch:
-- The potential fiscal costs of the restructuring and recapitalisation of Spanish banks initiated in May (see 'Fitch: Spanish Banking Reform Will Require State Assistance' at www.fitchratings.com [31]);
-- Prospects for the Spanish economy in light of the latest episode of the systemic eurozone crisis triggered by the inconclusive 6 May Greek general elections result;
-- The credit and funding profile of regional governments (see 'Fitch Downgrades
8 Spanish Autonomous Communities; Negative Outlook' dated 31 May at www.fitchratings.com [31]); and
-- The overall outlook for public finances following the announcement on 18 May of a second upward revision in the general government budget deficit in 2011 to 8.9% of GDP, compared to 8% estimated by Fitch in its last review of Spain in January.
The dramatic erosion of Spain's sovereign credit profile and ratings over the last year in part reflects policy missteps at the European level that in Fitch's opinion have aggravated the economic and financial challenges facing Spain as it seeks to rebalance and restructure the economy. The intensification of the eurozone crisis in the latter half of last year pushed the region and Spain back into recession, exacerbating concerns over sovereign and bank solvency. The absence of a credible vision of a reformed EMU and financial 'firewall' has rendered Spain and other so-called peripheral nations vulnerable to capital flight and undercut their access to affordable fiscal funding. Spain has been especially vulnerable to a worsening of the eurozone crisis because of the high level of net foreign indebtedness (around 90% of GDP) and fragile confidence in its capacity to implement fiscal consolidation and bank restructuring in a timely fashion.
Spain's investment grade status remains supported by a relatively high value-added and diverse economy as well as political and social stability despite very high unemployment. Competitiveness and export performance are improving and the trade balance on goods and services is expected to post a surplus this year. The rating is also supported by the Spanish government's commitment to wide-ranging structural reform to improve the efficiency of public services and strengthen the budgetary and fiscal framework; enhance the flexibility of the labour market; and foster competitiveness and the growth potential of the economy. Moreover, securing public debt sustainability is within reach if the government is successful in reducing its budget deficit to 3% of GDP by 2014 and in light of the economy's long-run growth potential of between 1.5% and 2% or higher if the structural reform agenda continues to be pursued.
Spain's investment grade rating is premised on EMU remaining intact and Fitch's judgment that the ECB, EFSF/ESM, and IMF, will, in extremis, provide financial support to prevent a fiscal funding crisis. Moreover, Spain's 'BBB' rating incorporates Fitch's expectation that Spain will secure financial support from its European partners for the restructuring and recapitalisation of the Spanish banking sector, though not necessarily a full-fledged policy-conditional external funding programme.
PUBLIC FINANCES
Since Fitch's last formal review of Spain's sovereign ratings in January, the
2011 outturn for the general government budget deficit has twice been revised upwards to 8.9% from 8% of GDP. Local and regional governments accounted for around two-thirds of the overshoot relative to the 2011 budget deficit target of 6% and remain a source of fiscal risk. Fitch recently downgraded eight regional governments in light of the expected increase in regional indebtedness and worsening economic and financing environment.
The settlement of outstanding payment arrears incurred by sub-national administrations and other 'one-off' operations will increase GGGD by 5.5% of GDP in 2012. Fitch expects that bank recapitalisation will add a further 6% of GDP to government debt during 2012 and 2013. Combined with a worsened outlook for the economy and higher interest payments, GGGD/GDP is projected by Fitch to peak at 95% in 2015 compared to the agency's previous projection of a peak of 82% in
2013 (the latter broadly corresponds to the government's current forecasts).
Under a scenario whereby the recession is more severe than forecast (-2.7% and -1.5% contraction in real GDP in 2012 and 2013 respectively compared to -1.9% and -0.5% assumed in Fitch's baseline projections), deficit reduction less rapid (3% primary budget deficit in 2013 compared to 1.4% assumed in the baseline) and bank recap costs are higher (9% of GDP rather than 6%), government debt would peak above 100% of GDP by 2014. Nonetheless, even under this negative scenario, government debt would stabilise reflecting Fitch's analysis and judgment that public debt sustainability is within reach, albeit at a high level of indebtedness that offers very limited fiscal space to absorb further negative shocks.
The Spanish government is expected to retain access to market financing for fiscal purposes, albeit at an elevated cost. Resolution of the banking crisis, progress on deficit-reduction and on-going structural reform combined with steps at the European policy level towards resolution of the eurozone systemic crisis would support a normalisation of funding costs and enhance confidence in the sustainability of public debt.
FISCAL COSTS OF BANK RESTRUCTURING
Fitch initiated a review in May of its previous assessment that the recapitalisation of Spanish banks would incur a fiscal cost of around EUR30bn (3% of GDP). On 25 May, it was announced that Bankia/BFA faces a EUR19bn capital shortfall. Fitch now expects the fiscal cost of bank restructuring and recapitalisation to be in the range of EUR50bn to EUR60bn and in a negative stress scenario, the cost could rise to EUR90bn- EUR100bn. A detailed description of Fitch's analysis of the potential capital requirements of the Spanish banking system is set out in an accompanying comment, "Fitch: New Base Case Indicates Spanish Banks Need EUR50bn to EUR60bn Capital".
Fitch expects Spain to secure external financial support for the recapitalisation of medium-sized banks and savings banks which would help restore confidence in the banking sector as a whole. The core of the system - Santander, BBVA and La Caixa - will not require assistance in meeting more stringent provisioning and capital requirements and underpin Fitch's confidence that the fiscal costs of restructuring the banking sector remain manageable from a sovereign credit and rating perspective.
Recourse to external funding for bank recapitalisation underscores the constrained financing flexibility of the sovereign to respond to adverse shocks.
Nevertheless, securing low cost and long duration funding from European partners to assist in the restructuring of the Spanish banking sector is consistent with Spain's current sovereign rating. If effective in restoring confidence in the banking sector and easing the fiscal burden of restructuring, such support would be credit positive.
NEGATIVE OUTLOOK
The Outlook on Spain's sovereign ratings remains Negative, indicating a heightened risk of further downgrades. The Negative Outlook primarily reflects the risks associated with a further worsening of the eurozone crisis, notably contagion from the ongoing Greek crisis (see 'Fitch: Re-Run Elections Would Be Critical for Greece, Eurozone', dated 11 May at www.fitchratings.com [31]). Spain's sovereign ratings at 'BBB' are robust to some further deterioration in the economic and fiscal outlook and somewhat greater than expected fiscal cost of bank restructuring, as well as to receipt of temporary external financial support for bank recapitalisation. However, Spain's high level of foreign indebtedness and prolonged economic weakness as it deleverages and rebalances does render it vulnerable to negative economic and financial shocks. A loss of market access for budgetary funding and consequent reliance on external policy-conditional financial support would prompt a further review of Spain's sovereign ratings.
Agreement on eurozone reforms that would strengthen confidence in the monetary union's long-term viability and measures to ease the severe financial and economic strains currently evident across the region would be supportive of a stabilisation of Spain's sovereign ratings. Along with the successful adjustment of the Spanish economy, supported by ongoing structural reform that enhances competitiveness and its growth potential, upward pressure on Spain's sovereign ratings could emerge over the medium term.