Europe Prepares for Bloodbath Open After Ireland Lowered By S&P To AA- From AA, Outlook Negative

From S&P:

Overview

  • The projected fiscal cost to the Irish government of supporting the Irish financial sector has increased significantly above our prior estimates.
  • We are therefore lowering our long-term sovereign credit rating on the Republic of Ireland to 'AA-' from 'AA'.
  • The negative outlook reflects our view that a further downgrade is possible if the fiscal cost of supporting the banking sector rises further, or if other adverse economic developments weaken the government's ability to meet its medium-term fiscal objectives.

Rating Action

On Aug. 24, 2010, Standard & Poor's Ratings Services lowered its long-term  sovereign credit rating on the Republic of Ireland to 'AA-' from 'AA'. At the  same time, the 'A-1+' short-term rating on the Republic was affirmed. The outlook is negative. The transfer and convertibility assessment remains 'AAA', as it is for all members of the European Economic and Monetary Union.

The downgrade to 'AA-' applies to other ratings that are dependent on the sovereign credit rating on Ireland, including the issuer credit rating on the National Asset Management Agency (NAMA), and the senior unsecured debt ratings on government-guaranteed securities of Irish banks (see "Ratings List" below).
 
Rationale

The downgrade reflects our opinion that the rising budgetary cost of supporting the Irish financial sector will further weaken the government's fiscal flexibility over the medium term. In light of the recent announcement of new capital injections into Anglo Irish Bank Corp. Ltd. (BBB/Watch Neg/A-2), our updated projections suggest that Ireland's net general government debt will rise toward 113% of GDP in 2012. This is more than 1.5x the median for the average of eurozone sovereigns, and well above the debt burdens we project for similarly rated eurozone sovereigns such as Belgium (98%; Kingdom of; AA+/Stable/A-1+) and Spain (65%; Kingdom of; AA/Negative/A-1+).

After a decade of rapid credit growth, which in our view greatly increased the risk profile of Irish banks, the Irish government has adopted what we view as a proactive and transparent approach to dealing with the financial sector's difficulties. We believe this should help foster a gradual recovery of the Irish economy over the medium term. Nonetheless, we believe that the government's support of the banking sector represents a substantial and increasing fiscal burden, which in our view will be slow to unwind.

We have increased our estimate of the cumulative total cost to the government of providing support to the banking sector from about €80 billion (50% of GDP; see "Ireland Rating Lowered To 'AA' On Potential Fiscal Cost Of Weakening Banking Sector Asset Quality; Outlook Negative," published June 8, 2009, on RatingsDirect) to €90 billion (58% of GDP). For details on how our 2010 estimate of Ireland's general government debt compares to official estimates, see Standard & Poor's commentary "Explaining Standard & Poor's Adjustments To Ireland's Public Debt Data," also published today.

Our estimate includes two main components: the upper end of our estimate of the capital we expect to be provided by the Irish government to improve the solvency of financial institutions, and the liabilities we expect the government to incur in exchange for impaired loans acquired from the banks.

We have increased our estimate of the cost to the Irish government of recapitalizing financial institutions to €45 billion-€50 billion (29%-32% of GDP) from €30 billion-€35 billion (19%-22% of GDP). These revised projections take into account the Irish government's recent announcement that it will inject further capital into Anglo Irish bank, bringing the total authorized so far for that institution to €24 billion (15% of GDP). In our view, the total cumulative amount of capital injected into Anglo Irish by the government could reach €35 billion (22% of GDP) over time. The higher capital injections relate to the recognition of worse-than-expected deterioration in Anglo Irish's asset quality. We believe similar developments could take place at some other Irish banks.

The second component of our estimate of the aggregate fiscal cost to the Irish government of providing financial system support relates to obligations to be issued by NAMA and its subsidiary entities. The face value of the total banking assets that we expect NAMA to acquire is about €80 billion. We expect NAMA to acquire these loans at a significant write-down. Our estimate of the haircut likely to be applied to the aggregate portfolio has increased slightly to 46% from 45% since our June 8, 2009 publication. As a result, our estimate of NAMA debt issuance has decreased to €40 billion from €43 billion. NAMA's own business plan applies a discount of 50% on the nominal amount of loans it expects to be transferred from the banks.

Absent the banking sector support described above, our projections indicate that Ireland's gross general government debt would in any case be on an increasing trend reaching 92% of GDP by 2014. Over the same period we expect net general government debt would reach 72% of GDP, which includes our estimate of the Irish government's liquid assets (cash and cash-equivalent) equal to 20% of GDP. Taking into account our estimates of likely future recapitalization costs to the Irish government and NAMA debt issuance we expect gross and net debt to reach 136% and 115% of GDP, respectively, by 2014.

Our working assumption is that the remainder of the government's capital injections into the banking sector will take place in 2010--although in reality they may be distributed over a longer period of time. We view these capital injections into the banking sector as having an extraordinary impact on the general government deficit in that year. As a result, the headline deficit could increase to 35% of GDP.

However, our view of the Irish government's underlying fiscal consolidation program is broadly unchanged. We expect the underlying deficit, net of these recapitalization costs, to reach 11% of GDP in 2010, compared with 15% of GDP in 2009. We project the deficit to reduce toward 5% of GDP by 2014. The government forecasts the general government deficit to fall below 3% of GDP in 2014. Data on the cumulative exchequer balance over the first seven months of 2010 indicate that a sharp decline in capital spending has reduced the overall exchequer deficit (the largest component of the general government deficit) to 6.5% of GDP in 2010 from 10.3% of GDP in 2009.
 
Outlook

The negative outlook reflects our view that the rating could be lowered again if--as a result of its support for the financial sector or due to a more sluggish economic recovery--the government's fiscal performance improves more slowly than we currently assume. Conversely, the outlook could be revised to stable if the Irish government looks more likely to achieve its fiscal target for the underlying general government deficit of less than 3% of GDP by 2014, or if the banking sector stabilizes more quickly and at a lower fiscal cost to the government than we now think likely.