Chart Of The Day: The EFSF Is Already Trading As AA+, Or Why The French AAA Rating No Longer Matters

Following the S&P "technical glitch" on Thursday which sent out a bizarre notice to a few subscribers notifying that a rating action on France is imminent, FrAAAnce is up in arms and demanding S&P blood. The reason: as everyone knows by now, the sanctity of the Eurozone is now contingent on those three A letters more than any other variable, because without said rating, France becomes ineligible for EFSF funding purposes (at any rating less than AAA), the EFSF's sole 'pristine' backer becomes Germany, and sends the EFSF yield curve into a tailspin, as it glaringly painfully obvious that Germany alone can't fund the trillions needed to preserve the Eurozone and purchase rolling Italian and other PIIGS debt. Yet one look at the yield curve of the EFSF as it already stand confirms that the market is not waiting for S&P, Moody's or any other rating agency, as it is now just a matter of time: after all recall that S&P itself said that it "would likely downgrade the credit ratings of France, Spain, Italy, Ireland and Portugal if the euro zone slips into another recession." Well as of yesterday, the EU itself warned the Eurozone may slump into "a deep and prolonged recession."The result: as of the past few days the EFSF no longer trades with an AAA implied rating. In face as can be seen on the chart below analyzing regression curves for various rating strata, the EFSF is now AA+ at best. Simply said, this means that the bond market has once again voted, and completely oblivious of the noise that is the puppet changes at the top in Italy and Greece, is already preparing for the next contingency casualty, which after France, is just one... at least in Europe.

And here is the salient section from the S&P October 20 Eurozone "Stress Test" - the bolded text is all that matters:

This new stress test updates our scenario analysis published on March 22, 2011. It's split into two parts:

In the first part, we review our base-case projections (very low growth for the European Economic and Monetary Union [eurozone]) and the potential impact on our rated universe of a double-dip recession (Scenario 1) and of a double-dip recession plus an interest rate shock (Scenario 2), with stress intensity ranging from modest to substantial depending on the jurisdictions. With the exception of Greece--where we assume a 60% haircut on sovereign debt, which is consistent with our recovery rating of '4' on the sovereign's debt--we do not assume any other European sovereign debt restructuring to occur under both scenarios.

The key projections from our stress scenarios are that:

  • The impact would be hardest on sovereigns and sectors most closely aligned with the credit fortunes of governments, such as government-related entities, local and regional governments, and banks.
  • Sovereign ratings on France, Spain, Italy, Ireland, and Portugal likely would be lowered by one or two notches under both scenarios.
  • Under Scenario 1, the Tier 1 ratio of 20 banks in our sample of 47 could fall below 6%. (Under Scenario 2, the number of banks affected rises to 21.) We assume that this would require recapitalization by their governments to raise the ratio to 7% for a total cost that we estimate to be about €80 billion (€90 billion). We infer that the overall eurozone-wide recapitalization cost could amount to about €115 billion (€130 billion).
  • Speculative-grade corporate defaults would likely increase to between 9% and 13% under the scenarios, and industrial sectors most exposed to rating downgrades would likely include steel and aluminum, downstream oil and gas, building materials, and forest products.
  • Covered bond programs in Italy, Portugal, and Spain could be lowered by several notches under our criteria, reflecting the potential downgrades of issuing banks.
  • The deterioration of collateral securing structured finance transactions in Italy, Portugal, and Spain could contribute to a downgrade rate of at least 25%-30%, with junior tranches most affected.
  • If all counterparties to structured finance transactions were to be downgraded by one notch and did not replace themselves, we could downgrade the senior notes in approximately 10%-15% of securitizations.
  • Rated insurers in Italy, Spain, and Portugal, or with significant operations in or exposures to these countries, or large U.S. equity portfolios in their life operations, potentially could see rating actions limited to between one and two notches on average.
  • Increased yields under Scenario 2 would actually come as a relief to life insurers with guaranteed yield products.

In the second part of the report, we also assess the funding capacity of the EU and the IMF to support our base-case projections as well as stressed borrowing requirements from Greece, Ireland, Portugal, Italy, and Spain in order to keep borrowing costs at levels that don't exacerbate solvency issues.

Our key projections from these tests are that:

  • The current arrangements likely would be sufficient under our base-case projections if the EU and International Monetary Fund (IMF) were to support 100% of the borrowing requirements for Greece, Portugal, and Ireland, and up to 10% of the borrowing requirements for Spain and Italy.
  • These arrangements likely would be insufficient under a double-dip recession scenario to support 100% of the stressed borrowing requirements for Greece, Portugal, and Ireland, and up to 30% of those for Spain and Italy.
  • Under such highly stressed conditions, we calculate that there would be a shortfall of €287 billion between the joint lending capacity of the EU support mechanism and the IMF, representing about 2.7% of the aggregate 2010 GDP for eurozone member states.

Tabular summary: