The European AIG: How Moody's Downgrade Of Greece Can Start The Avalanche

As one so vividly remembers, probably the key catalyst that set off the chain of events last fall following the collapse of Lehman were the closed loop (and much delayed) downgrades of AIG, which in a span of hours went from AAA to much lower, thus springing various collateral requirements which the company could not satisfy, and in turn forcing even more downgrades, until ultimately it became clear that the firm (like most others on Wall Street) is merely a lot of hot air and unjustified valuations. Ironically, the rating agencies, and more specifically Moody's, could once again be the catalyst for the much anticipated collapse of the European house of cards, which as all now know, has Greece as its weakest link. The threat: a Greek downgrade by Moody's from its current rating of A1 to anything with a B handle would make the country's sovereign debt ineligible for ECB collateral in 2011, sparking a sovereign liquidity crisis. Recall that both Fitch and S&P recently downgraded Greece to BBB+, implying that the fate of Greece, and specifically its ability to access cheap and quick capital via the ECB, could be cut off on the whim of the rating agency that Warren Buffett himself can't stop selling enough of.

Goldman's take on this interlinked situation should have investors worldwide very worried:

When S&P downgraded Greece to BBB+ (from A-) yesterday, they de facto handed the critical decision of eligibility for Greek sovereign debt at the ECB over to Moody’s.  This is a bizarre and ultimately untenable situation for the ECB.  Therefore, unless we get a major improvement in the Greek fiscal outlook during the next few months, the ECB would want to rectify the situation by revising its eligibility criteria for sovereign debt.

The ECB’s rules state that Euro-zone sovereign bonds are eligible for ECB collateral as long as they have at least one A- rating (or better) from one of the three credit rating agencies.  (This rule has been temporarily modified for the period until the end of 2010 to a minimum of a BBB- rating, with a 5% haircut if a credit is rated BBB- by all three agencies.)  Fitch downgraded Greece to BBB+ on December 8, so when S&P moved to the same rating yesterday, Moody’s became the de facto decision maker on Greek eligibility at the ECB.  Currently, Moody’s is a significant outlier in terms of its rating; its A1 rating for Greece is three notches above Baa1 (the equivalent of BBB+) which would cut them off from the ECB’s facility from the beginning of 2011.

The danger, as Goldman highlights, is that the fate of the first domino is in very tenuous hands:

Now, however, the unthinkable - that the ECB would not accept sovereign securities from a member as collateral - has become a measurable risk, and one exclusively controlled by Moody’s.  Clearly untenable!

What will happen now? This is what Goldman analyst Erik Nielsen believes:

1. If the Greek fiscal outlook improves significantly during the next few months, then the ECB might decide to take the chance that Moody’s won’t downgrade them by three notches (or more).  Such an improvement could come via the implementation of the government’s stated program, plus maybe a few more safeguarding measures (after all, Almunia called the present program “steps in the right direction”, which presumably falls short of an assessment of being “sufficient”.)  Alternatively – or in addition – the improvement of the outlook could come through a substantial non-commercial financing package, from the EU (which would require some twisting of the rules), bilateral help in the form of lending or guarantees, and/or help from the IMF.  (My suggestion would be a European emergency facility, e.g. with a rolling guarantee, as I discussed in “The way forward for Europe post-crisis”, July 28, 2009; Global Economics Paper No 186.)

2. Since the ECB could not be seen to change its rules in reaction to Moody’s (potential) downgrades, they would have to be confident very soon that such downgrades are not forthcoming.  If not sufficiently confident, they would want to revise their eligibility criteria very soon, probably within a few months.  If so, I think they have two choices: They could announce a further extension beyond 2010 of the present temporary regime, or they could introduce a version of the “conventional warfare threat” that I proposed back in 2005 (second bullet above.)

And so Moody's is once again caught in a vise: if it does the right thing and express an objective opinion it will likely precipitate the next crisis, this time in Europe. If it keeps mum, under the behest of Trichet and Greek politicians, it will lose yet more credibility, without any clear guarantees that the fiscal situation in Greece won't deteriorate sufficient to alone merit a solvency/liquidity crisis. But as everyone knows, in this global push to extend and pretend, the one certain thing is that Moody's will rush to make any decision. After all - 3 years down the road things look so much better, if one simply does the Birinyi approach of extrapolating the market using a ruler as a trendline. And if that doesn't work, Moody's can always just downgrade itself to D sooner or later and end its own misery.