Analysis: S&P downgrades to cut EFSF firepower, boost firewalls

BRUSSELS Fri Jan 13, 2012 1:52pm EST

BRUSSELS (Reuters) - Euro zone rating downgrades expected to be announced on Friday will substantially cut the lending power of the EFSF, especially if the euro zone bailout fund insists on keeping its AAA rating, and will make it significantly harder to multiply its resources.

Standard & Poor's expected cut in France's AAA rating by one notch would for example reduce the effective firepower of the European Financial Stability Facility by around 20 percent, from 440 billion euros to 360 billion, one euro zone official said.

Downgrades of other countries -- including AAA-rated Austria -- could further reduce the EFSF's ability to issue top-rated bonds, officials and economists said.

That could in turn convince euro zone leaders to allow the EFSF, set up in May 2010 and used to bail out Ireland and Portugal, to issue debt rated below AAA, which would actually boost the EFSF's lending capacity, some officials said.

Or it could prompt euro zone leaders to decide at a summit in March to scrap the combined 500-billion-euro lending ceiling of the EFSF and its permanent successor, the European Stability Mechanism, which is supposed to come into force in July.

"It is clear that the actual firepower of 440 billion no longer holds, because of the way it was calculated," one euro zone official involved in the EFSF talks said when asked about the expected S&P downgrades, on which S&P has not commented.

But the official added that the AAA-rating of the EFSF, which has so far issued around 20 billion euros of top-grade paper, should not be seen as untouchable.

"The AAA rating of the EFSF should not be a sacred cow, because it does not even make sense -- it is not a reflection of the euro area, it is a reflexion of a small part of it," the official said.

The EFSF's lending capacity is based on guarantees from euro zone governments. Because only 6 of the 17 governments are currently AAA-rated, all member states have to provide over-guarantees to ensure that the EFSF remains AAA rated. Those commitments total 780 billion euros.

But where there were 6 AAA countries, there are now set to be 4, and several of the remaining 11 countries could also find their credit positions lowered. The overall impact will be to suck power from the EFSF and make it that much harder to scale up the resources that are already committed to the facility.

BASED ON CREDIT AGENCY MODEL

When they were asked to rate the EFSF, the three major ratings agencies decided that they would base their calculations only on the AAA-rated countries, assigning a zero value to the remaining guarantors, the official said.

To maintain a AAA stamp after the downgrades, therefore, the EFSF would have to get even more guarantees from the four AAA countries left-- the Netherlands, Germany, Finland and Luxembourg -- which is highly unlikely.

The solution could be to allow the EFSF to issue bonds rated below AAA. That would immediately boost the firepower of the fund, because the amount of existing guarantees would cover a much higher issuance of lower-rated debt.

The loss of France's AAA is the most likely trigger.

"If France is downgraded, maybe the EFSF can issue bonds at less than AAA and pay a bit more, and this would have to be borne by the beneficiaries, but the end result for the EFSF would be good," the official said.

A lower rating for the EFSF would mean it would have to pay more to borrow on the market, in order to lend on to euro zone countries already cut off from the market.

But all the costs of the EFSF are paid by the benefitting countries -- Ireland and Portugal -- for which paying a little bit more for EFSF loans is still a much more appealing option than borrowing on the market at yields in double digits.

COMBINED FIREPOWER

To boost its ability to bailout countries when Italy and Spain came under market attack, euro zone leaders brought forward by one year the launch of the ESM to July 2012. The ESM is to run in parallel with the EFSF for one year, to mid-2013.

Under the current agreement, the combined lending capacity of both the EFSF and ESM cannot exceed 500 billion euros, but euro zone leaders agreed to review that cap in March.

With EFSF firepower diminished by S&P'S downgrade, the leaders are more likely to overcome Germany's objections and remove the combined lending limit, officials suggest.

"We will see pressure towards that, rather than some new steps inside the EFSF," the euro zone official said. "It would be easier politically to do this, than to say 'we will need more guarantees from the remaining AAAs and others'."

The decision to remove the combined lending limit might be made easier by the fact that the downgrade is likely to scupper the chances of the EFSF to attract external investors to invest alongside it in euro zone debt -- the leverage idea.

Euro zone leaders have put much store by the idea in recent months, but it now looks like a near non-flyer.

"It's about perception, so a downgrade basically kills off the leveraging, I think the ESM is looking like the only vehicle they can use now," said Steen Jakobsen, chief economist at Saxo Bank.

"With a downgrade, I'd say there's an 80 percent chance a leveraged EFSF will not get off the ground," he said.

The ESM, which will have paid-in capital of 80 billion euros and callable capital of 620 billion euros, would be a much more attractive partner for the markets, but there are still several kinks to be worked out before that facility can start work.

"The downgrades at most cement the negative sentiment we've seen towards the EFSF leveraging," said Ebrahim Rahbari, a senior economist at Citigroup.

"The game plan has shifted towards trying to start with a fresh slate by bringing forward the ESM and focusing on a capital infusion that should add some cushion for investors," he said.

(Reporting By Jan Strupczewski and Robin Emmott, editing by Luke Baker)