Oct 21- The possible effects of a double-dip recession, or a double-dip recession combined with an interest rate shock, on Standard & Poor’s sovereign, bank, corporate, and structured finance ratings in Western Europe are examined in a new report published by Standard & Poor’s Ratings Services. Titled “Stressing The System: Assessing The Capacity Of The EU And IMF To Support A Eurozone Under Strain,” the report outlines two stress scenarios that are more severe than the assumptions underlying our current ratings. These scenarios are not our central expectation, but a simulation of the possible outcomes if such events were to occur.
The report also examines the funding capacity of the EU and International Monetary Fund (IMF) to support stressed borrowing requirements from Greece, Ireland, Portugal, Italy, and Spain in order to keep borrowing costs at levels that don’t exacerbate solvency issues.
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 (a double-dip recession), the Tier 1 capital ratio of 20 banks in our sample of 47 could fall below 6%. (Under Scenario 2 [a double-dip recession and interest rate shock], 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 EUR80 billion (EUR90 billion). We infer that the overall eurozone-wide recapitalization cost could amount to about EUR115 billion (EUR130 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.
The main projections from our assessment of the funding capacity of the EU and IMF are that:
-- The current arrangements likely would be sufficient under our base-case projections if the EU and 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 EUR287 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.
“Although our scenarios take into account various debatable assumptions, we believe that they illustrate the likely general direction under given conditions,” said Blaise Ganguin, Standard & Poor’s Chief Credit Officer, EMEA. “Beyond the likely downgrade of a number of sovereigns if such events came to pass, our scenarios suggest that current support mechanisms may not be sufficient if conditions deteriorate beyond current expectations.”