That’s if. Despite the persistence of US arguments along the lines of “if us why not them?” there’s no suggestion any rating action is imminent. The biggest rating agencies on Wednesday fell over themselves to reaffirm French sovereign debt’s AAA rating.
The prudent see danger and take refuge, though; Credit Suisse’s Andrew Garthwaite (my apologies for previously assigning incorrect authorship) has cogently assessed the possible scenarios should the senior tranche of the ‘EFSF CDO‘ be downgraded. As we’ve noted before, the “critical issue” for Credit Suisse is what this does to the EFSF’s lending capacity, given that France currently contributes 22 per cent of the guarantees, rising to 35 per cent if Italy and Spain were unable to contribute.
There are at least six ways a downgrade could affect the EFSF, write Credit Suisse. These are not mutually exclusive and some are fairly straight forward. Nevertheless we found them quite useful, especially for those newish to the scpectre of a French downgrade. The most likely CS scenario is that a French downgrades results in the loss of the EFSF AAA credit rating and thus the beast begins to eat itself and funding costs increase. But there are others…
1) The EFSF’s credit rating is downgraded, but the facility continues to operate as before, with higher funding costs (we estimate around 100bps, which corresponds to the gap between yields on French and Belgian debt). We think this is the most likely option. We note that after a French downgrade none of the three biggest sovereign borrowers globally would have a AAA-rating (Japan, US and France) – i.e. many other sovereign borrowers are funding themselves without problems in spite of the absence of a AAA-rating.
2) The ECB buys more peripheral European debt. The ECB makes up for the reduced lending capacity of the EFSF by increasing its purchases of peripheral European sovereign debt in the secondary market (having bought an estimated €80bn so far). This would amount to a form of soft QE (as its would lead to a deterioration of the quality of the ECB’s balance sheet) – or even hard QE (if the purchases are not sterilized, thus leading to an increase in the size of the ECB balance sheet). We note that this scenario could occur in combination with scenario 4 above. The only problem is that this would require the ECB to give up another one of its principles (as they would have to concede that their buying is not just “temporary”, i.e. only in place as long as the EFSF is not fully operational).
3) The EFSF retains its AAA-rating in spite of the French downgrade with no impact on its lending capacity and cost of funding (low probability)
4) The EFSF reduces its lending capacity in order to retain its AAA-rating… low probability, given the perceived need to increase the size of the EFSF to ensure that Spanish and Italian funding needs could be met. On our calculations, the EFSF would require an effective lending capacity of around €1tn to avoid contagion
5) Germany and the other AAA Euro-area countries (Holland, Finland, Austria, Luxemburg) increase their contribution to the EFSF to ensure the AAA-rating is maintained without a reduction in the lending capacity… low probability, given political resistance in these countries to increase their burden in the bail-out efforts
6) Core Europe stop supporting the periphery – the main risk is that the remaining AAA-rated countries in the Euro-area would worry about the risk to their own credit rating – and would decide that it is no longer in their interest to support the periphery (or that the domestic political situation makes it preferable to stop doing so). Without support from core Europe, we think a break-up of the euro would be inevitable. We continue to think this is unlikely – but the chances of it happening would surely increase if France were to lose its AAA-rating.
The obvious point to make is that these scenarios are all connected — an EFSF downgrade may be most likely to happen but it’s unlikely to happen in isolation given the potential knock-on effects of a French downgrade in Italy and Spain.
For what it’s worth, upon a downgrade, Credit Suisse places the probability of “the European situation becoming a systemic crisis”, 25 per cent, up from 10 per cent now.
(What does a crisis need to do these days to be called “systemic”?)
Related link:
Eventually, French Spreads Fail (E.F.S.F.) – FT Alphaville