Tuesday, June 14, 2011
As the rating agencies trip over themselves to downgrade sovereign credit, Greece yesterday became the 'World’s Lowest Credit Rating by S&P'. This is largely meaningless for bond pricing, since Greece is already trading at very distressed levels - the curve is inverted, and the two year bond is trading at 26%. However, the downgrade of other Euro area countries could have broader implications for the EFSF (and then ESM) liquidity facility.
Ther are two reasons why ratings matter for the EFSF (European Financial Stability Facility):
(1) the 6 triple-A country guarantees facilitate the triple-A rating on the EFSF structure itself.
(2) countries that fall under the umbrella of the EFSF no longer contribute to the guarantee of the structure.
The table below illustrates the current EFSF guarantee structure (part of the credit enhancement to receive a triple-A rating) - details of which can be found here - and their associated foreign currency long-term ratings by the three major rating agencies.
The triple-A countries are highlighted in orange, of which Germany and France contribute the largest shares to the EFSF guarantee structure, 29.1% and 21.9%, respectively. Estonia, a member of the Euro area, is not part of the structure, at this time but will join soon.
Of the triple-A countries, France is perpetually the weak link, although it's been reaffirmed as stable by the three agencies. However, if France, for example, were to drop below triple-A, the entire structure would likely lose its AAA rating - this would be a problem for overall funding costs.
Greece, Ireland, and Portugal do not contribute, as they are currently under EFSF-funded programs. Before Portugal signed up for austerity (strict austerity is a condition for EFSF loans), it guaranteed 2.6% of the structure. So, as the countries fall under the blanket of the EFSF facility, they consequently fall out of the guarantee structure. The process leaves a hole to be filled by the remaining countries.
Having to cover 2.6% of the guarantee structure is not a big deal - but if Spain, Italy, or even Belgium - Belgium's rating was reaffirmed today by S&P - were to require loans, the burden would fall on fewer countries to cover the loss.
So, although Greece's downgrade is not a 'big deal', the downgrade of a triple-A country or a larger economy that leads to spread widening and perhaps EFSF lending would.
This is not over. Greece will likely get its funding needs covered through loans under the EFSF facility (and even voluntary debt rollover, however, I am skeptical about this prospect), but that will not be the end of the banking crisis.