The Mystery of the Triple A rating and the Reincarnation of the CDO

Speaking last month, Christine Lagarde stated that if banks could raise sufficient funds on the open markets to meet their liabilities and Basel III requirements within the certified time (between 7 and 9% of capital to risk-weighted assets) then governments should step in and lend to the banks. No-one, it would seem, wants this outcome. The banks retaliated with claims that they were not in need of a second "bail out", and there aren't many taxpayers who would be happy with another round of bank bailouts.

But it's not just banks. At the end of last year, Ireland needed a bailout. Greece and Portugal swiftly followed, and now Italy and Spain have joined the list of those 'giving cause for concern'. The European Financial Stability Facility was set up following the Irish bailout as a means of dealing with the problem. At the time, no-one expected, and likely intended, for the fund to be used. It was intended merely as a 'back up' plan that would encourage the market to lend to Ireland. But this never happened, and now - unable to fulfil the government guarantees of banks - Ireland cannot raise money on the markets. Estimated interest rates of 7% on Irish government bonds being unsustainable, Ireland had to look elsewhere, and the EFSF was the remaining option.

The EFSF, it is anticipated, will borrow €750 trillion from the markets and will lend to countries in need.The means of the EFSF are combined with loans of up to € 60 billion coming from the European Financial Stabilisation Mechanism (EFSM), i.e. funds raised by the European Commission and guaranteed by the EU budget, and up to € 250 billion from the International Monetary Fund. In other words, the fund is a special purpose vehicle (SPV) set up to lend money to countries that can't issue bonds on the markets. Investors who won't lend to Ireland and Spain because of their poor economic situations are being asked to lend to the EFSF, which will in turn lend ot Ireland and Spain. The core countries of the Eurozone have agreed to guarantee the fund, though, so each are liable for the defaults of others. Germany, France and Italy are the largest contributors, making Germany, France and Italy liable in large part for the debts of countries who borrow from that fund. So far so good.

All of the big three ratings agencies were asked to assign the fund a triple A rating - the highest possible, and each agreed. This was justified on the basis that those countries guaranteeing the loans could afford to honour their guarantees. But the fund is essentially supplying loans to people who can't borrow anywhere else because it is unlikely they'll be able to pay the loan back. It's also guaranteed by countries who aren't solvent either (Ireland, Greece, Portugal, Spain and Italy are all guarantors too). Put this way, the triple A rating assigned seems surprisingly optimistic - reminiscent almost of the CDOs that came to symbolise the worst of the sub-prime mortgage crisis.

Of course, the CRAs have defended their actions, citing Germany's surplus and the structure of guarantees involved. Indeed, Scott Mather, Pimco fund manager, has stated that if the EFSF just loans to Ireland then the fund appears to be a fairly safe bet. The problem comes if and when more countries need to borrow from the fund. By guaranteeing Ireland's loan from the EFSF, Spain, for example, will have to set aside assets to cover the guarantee, leaving less room for manoeuvre should anything go wrong, and making it more likely to need to borrow from the fund itself. The more countries that borrow, the fewer guarantors there are, and the rating assigned will drop. In the worst case scenario, Germany, and to a lesser extent France, will be left lending to the rest of Europe, and most likely writing off a significant part of any loan. This - as we are all well aware - is well after the point at which politics steps in and marks the end of the single currency experiment - and is the worse case scenario.

It is worth noting a couple of final points. The AAA rating for the fund was necessary because the investment it is seeking to attract is mainly funds. Pension funds and other investors who usually look for low(er) risk vehicles that are investing the life savings of teachers, postal workers, etc. Ireland had its first bail out nearly one year ago. It followed IMF advice and introduced strict austerity measures. The economy has shrunk by 20%, unemployment is in the high teens and debt to GDP ratio has soared to over 100%. IMF advice hasn't solved anyone's problems, yet it is still being offered as the solution, in the form of a second bailout package. Greece is in the same situation. It is estimated that Greek debt will rise form €270 billion to €340 billion in four years time. This is predicated on the assumption that Greece follows IMF advice by introducing strict austerity measures. The problem is that Greece can't afford to service its current debt levels, let alone increased levels. Massive write offs are the only way that Greece is going to be able to default 'gently', although it does bring the wisdom and the function of the EFSF into question even further.

For more on this see NPR's Planet Money podcast on the issue. An FAQ factsheet on the EFSF is available here.

... and the downgrades continue

And so the banking crises and the sovereign debt crises rumble on, with endless meetings in Brussels that have so far achieved stupendously little given the time already devoted. We are being reassured that progress is taking place, so perhaps just a little longer...

In the meantime several more European downgrades have been occupying the rating agencies. On the 18th October Moody's cut Spain's sovereign credit rating, making it the last of the big three rating agencies to take such action, lowering the rating from Aa2 to A1. A couple of weeks before, Fitch had cut Spain's sovereign rating to A minus from double A, followed closely by a similar move by Standard and Poor's. Considering Spain's sovereign rating was triple A status until September last year, recent downgrades mark the latest turn in a significant drop. Moody's cited reasons of political uncertainty (further elections could see the conservative People's Party make huge gains in elections on November 20th), unrealistic deficit reduction plans (from 9.2 per cent of GDP last year to 4.4 per cent in 2012) with equally unrealistic growth figures (forecasts of 1.8 per cent growth have been estimated by Moody's to be closer to 1 per cent). Further reasons cited include the government debts of Spain's 17 autonomous regions, and the willingness of these to curb their spending.

Moody's have also downgraded both Belgium and Italy, the latter following a similar move by Standard and Poor's last month. Standard and Poor's have also downgraded three large Italian banks although it confirmed the ratings of 18 large banks - including the largest by assets. 21 regional banks were also downgraded. However concerns have been raised by the head of Italy's banking association and chairman of Monte dei Paschi, Giuseppe Mussari, that EU bank recapitalisation plans being discussed in Brussels could do more harm than good in Italy by forcing banks to hold 'unnecessary' amounts of capital and exacerbating the sovereign debt crisis. Italy's 10-year bond yield rose 7 basis points to 5.867 per cent on Tuesday, the highest close since before the European Central Bank began buying Italian bonds on August 8 to try keep down borrowing costs.

As negotiations to bail out Greece and the Euro with it continue in Brussels, Moody's has announced that it may change the outlook on France's triple A rating from stable to negative in the next three months. As is customary in such situations, a downgrade is neither forthcoming or imminent, but the mere prospect of such sends shivers through the markets and French banks' shares fell following the announcement. Moody's praised France's 'very high economic strength', its 'ample capacity to absorb shocks' and its 'favourable public debt maturity', along with political efforts aimed at fiscal consolidation. However, the global financial and economic crisis had, according to the rating agency, led to a deterioration in French 'government debt metrics'.

The agency stated that France's finances were now among the weakest of those countries which still had a triple A rating. France's public finances are not only looking vulnerable but French banks are heavily indebted to Greece. Standard and Poor's last week downgraded BNP Paribas by one notch from double A to double A minus citing exposure to Greek debt. What's more, major consequences could follow for France if Greece defaults on its liabilities and markets react poorly, or if there are any further defaults. Add in the fact that France has been gradually becoming less competitive for businesses over the past years - in contrast to neighbouring Germany - and it becomes easy to understand why Sarkozy might be worried. Moody's isn't alone, however, as Standard and Poor's included France in the role call of countries likely to see further downgrades in the case of a double dip recession - alongside Spain, Italy, Ireland and Portugal. France's public debt is approaching 90 per cent of GDP and so a downgrade could prove extremely painful, even though this figure is set to fall as France's budgetary deficit is brought down from 5.7% currently to 3% in 2013. These figures are - as most Eurozone projections - based on optimistic growth forecasts. France anticipates 1.75% over the next year. Most commentators doubt this will materialize, either making deficit reduction a longer-term goal, or necessitating further austerity measures in the run up to the election next year.

France is already committed to €158.5bn ($217bn) in guarantees for the new eurozone rescue fund, the European financial stability facility, which is equivalent to 8.5 per cent of GDP. It has also just agreed to guarantees for the failing Franco-Belgian bank Dexia. Now these don't matter much unless and until one of these fails, at which point the government is bound to step in. But it does mean that France has much less room for manoeuvre on its balance sheets than it did three years ago, leaving it vulnerable to further financial shocks. It is also limited in the resources it can supply to the European Financial Stability Fund (EFSF), and Germany's peas for a greater Greek write-off followed by French re-leveraging of banks is, as a consequence, increasingly difficult. Politically, at least, Sarkozy has hailed the AAA rating as 'untouchable', and while rating agencies take political direction into account, it will no doubt take more than a statement of intent to preserve France's rating.

UK financial firms downgraded by Moody's

The credit rating agency Moody's has downgraded the senior debt and deposit ratings of twelve UK financial firms, including RBS (down two notches from AA3 to A2), Lloyds TSB (down one notch from AA3 to A1), Nationwide and Santander UK. Nine Portuguese banks were also subjected to the same. While the agency stated that it did not believe that conditions had deteriorated, it attributed the downgrades to the belief that the UK government was less likely to bail out any of the institutions should they get into difficulties.
The removal of implicit government support for the banking sector was welcomed by Lloyds as necessary for the sector in the UK at least to stand on its own once again, however the news prompted falls in all the share prices, including for Barclays whose share price fell in accordance with the other banks despite the fact that it was not downgraded.

The Chancellor George Osborne stated that British banks were among some of the best capitalized in the world, and that the government were taking steps to address the "too big to fail" problem. Of course, detail is scant, and heralding capitalization levels and stress test successes should be taken, one feels, with a Dexia-sized pinch of salt. Moody's split the downgrades into three categories - those institutions still with a high likelihood of government support, a moderate level, and a low level of support. Unsurprisingly, the large banks including RBS and Lloyds fell into the first category, while the smaller institutions were split between the second and third.

While most UK banks have exposure to Irish sovereign debt, they are not exposed to other Eurozone countries in the same way as some of the European banks. There's more on this point, along with discussion of some interesting calculations carried out by French bank Natixis here.

S&P Downgrade Italian debt

Standard and Poor's yesterday downgraded Italian sovereign debt to A with a negative outlook. This means that further downgrades are still possible. This means that Italy's Standard and Poor's rating is now 3 notches below that assigned by Moody's, which announced last week its intention to review the Italian measures brought in to deal with the debt problems.

As is usual with these things, the base rate of borrowing rose, leaving yields on 10 year Italian bonds at 5.80% this morning, the highest since the European Central Bank started buying Italian and Spanish bonds in August, according to the FT. By contrast, 10 year German Bund yields this morning were at a low of 1.75%.

Standard and Poor's cited Italy’s “weakening economic growth prospects” and the difficulty of the “fragile governing coalition” being able to “respond decisively” to the crisis, however Berlusconi responded by calling the downgrade political. The Italian government passed an an austerity package just six days ago, however Standard and Poor's has clearly not been much reassured. It would appear that concerns surrounding Italy's ability to deal with the debt crisis are as much about political capability than fiscal stringency.

The Eurozone may be preoccupied with an imminent Greek default, and while this would be tricky and painful, Greece's economy could - just about - be propped up by the rest of the Eurozone, should it choose to do so. However the larger Italian economy is not in this position, and as such any prospect of Italian default should signal something akin to a "save yourselves" policy turnaround. And then there's Spain...

The European institutions have, predictably, reacted angrily to the news, and have threatened a third round of regulation of CRAs, setting up a wholly independent European rating agency. Commentators have largely been skeptical about this threat, but more here if and when the plan is taken forward.