Frankfurt am Main, November 30, 2012
Moody’s Investors Service has today downgraded the long-term issuer rating of the European Stability Mechanism (ESM) to Aa1 from Aaa, and is maintaining a negative outlook on the rating. At the same time, Moody’s has also downgraded the provisional long-term rating for the Issuer Rating and debt issuance programme of the European Financial Stability Facility (EFSF) to (P)Aa1 from P(Aaa), and is also maintaining a negative outlook. The short-term issuer rating of the ESM remains unchanged at Prime-1, while the provisional short-term rating of the EFSF remains at (P)Prime-1.
Moody’s decision was driven by the recent downgrade of France to Aa1 from Aaa and the high correlation in credit risk which Moody’s believes is present among the ESFS’ and ESM’s entities’ largest financial supporters.
Moody’s downgrade of France reflects the rating agency’s view that there has been a marginal diminution in the certainty that the sovereign will fulfil its financial obligations. France is the second largest contributor to the two entities’ financial resources, as a provider of callable capital in the case of the ESM and as a guarantor country in the case of the EFSF.
Moody’s view that there is a high correlation in credit risk among the entities’ supporters is consistent with the evolution to date of the euro area debt crisis and the close institutional, economic and financial linkages among the major euro area sovereigns. As a result, the credit risks and ratings of the ESM and the EFSF are closely aligned to those of its strongest supporters.
At the same time, Moody’s explains that both entities remain extremely highly rated at Aa1 because the ESM and the EFSF benefit from the following common credit strengths:
(i) Low leverage: the ESM has a maximum lending capacity of EUR500 billion, which is backed by subscribed capital of EUR700 billion; while the EFSF has a guarantee mechanism which results in an overcollateralisation of up to 165%; and
(ii) The creditworthiness of the members: both entities have a weighted median shareholder rating of Aa1 (changed from Aaa further to the downgrade of France’s government bond rating to Aa1); both the ESM’s and the EFSF’s purpose is to provide an inter-governmental support mechanism which extends financial assistance to members that are either unable to access the capital markets, or able to do so only at very high interest rates.
Moody’s acknowledges that the ESM benefits from credit features that differentiate it from the EFSF, including the preferred creditor status and the paid-in capital of EUR80 billion. However, in Moody’s view, these credit features do not enhance the ESM’s credit profile to the extent that it would warrant a rating differentiation between the two entities.
In a related rating action, Moody’s has additionally downgraded the ratings on all the debt securities that have been drawn down to date from the EFSF to Aa1 from Aaa.
A provisional rating for a debt facility is an indication of the rating that Moody’s would likely assign to future draw-downs from the facility, pending the receipt of documentation detailing the terms of the debt issuance.
RATIONALE FOR DOWNGRADE
The one-notch downgrade of the ESM’s rating to Aa1 from Aaa follows the downgrade of France’s government bond rating to Aa1 from Aaa on 19 November 2012. France’s share in the ESM capital key is 20.4%, second after that of Germany (27.1%), and corresponds to a callable capital commitment of EUR126 billion (out of the ESM’s total callable capital of EUR620 billion).
In common with many multilateral development banks (MDBs), the credit strength of the ESM rests in part on its certainty of being able to call on its members to fulfil their callable capital commitments. Among MDBs, the rating of the ESM is unusually reliant on the strength of its strongest financial supporters given (i) its highly concentrated potential exposure to weaker euro area member states, and (ii) the high credit risk correlation which Moody’s believes exists among its shareholders.
In the very unlikely event of France being unable to fulfil its obligations to the ESM, there is a reasonable probability that other non-Aaa supporters would not be able to do so either. Accordingly, the deterioration in the creditworthiness of France as the second-largest euro area member state (as reflected by the recent downgrade), which implies a marginally diminished certainty it would be able to provide support to the ESM, has a negative effect on the ESM’s creditworthiness.
Based on a scenario in which the ESM operates at full lending capacity (EUR500 billion), the ESM’s rating could only exceed France’s rating if it was assumed that either: (i) France would prioritise its callable capital commitments to the ESM over the payment of its own debt obligations should there be a need for such a prioritisation; or (ii) member states that have a lower rating than France are able to comply with their commitments to the extent that the ESM’s outstanding issuance is fully covered, even in the unlikely event that France defaults. Moody’s does not consider either to be likely.
Hence, the combination of France’s large ESM capital share and the elevated default correlation of euro area member states leads to the conclusion that, in such a scenario, the effectively accessible capital — subscribed capital of EUR700 billion minus the callable capital of defaulting countries — will likely fall short of covering the outstanding issuance. Accordingly, in light of its anticipated highly concentrated credit portfolio and the high correlation of euro area member states’ creditworthiness, Moody’s considers the ESM’s rating to be currently constrained by France’s government bond rating.
Similarly to the ESM, the one-notch downgrade of the EFSF’s rating to Aa1 from Aaa follows the recent downgrade of France’s government bond rating to Aa1 from Aaa. France’s share in the EFSF contribution key is 21.8%, second after Germany’s 29.1% share. France’s share corresponds to a guarantee commitment of EUR158 billion (out of EFSF’s total guarantee commitment of EUR726 billion). Further to France’s loss of its Aaa rating, only 67% instead of the previous 100% of the EFSF issuances are now backed by guarantees issued by Aaa-rated sovereigns. The full coverage of EFSF issuances by guarantees issued by Aaa-rated sovereigns had been a key factor for the EFSF’s Aaa.
In the very unlikely scenario of the French sovereign bond default, Moody’s does not expect that France would be able to fund its commitments to the EFSF. Furthermore, given the credit risk correlation of the EFSF guarantor countries, Moody’s considers it unlikely that lower-rated member states would be in a position to honour their own commitments to the EFSF and fully compensate for a potential shortfall arising from France. Hence, in light of the elevated credit risk correlation among the guarantor countries, the EFSF’s rating is – similar to that of the ESM – currently constrained by France’s government bond rating.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook on the ESM’s long-term rating reflects the negative outlooks on the ESM member states with significant capital contribution keys and high ratings. Specifically, the Aaa ratings of Germany (which holds a 27.1% share in the subscribed capital) and the Netherlands (5.7%), as well as the Aa1 rating of France (20.4%) all have negative outlooks.
The negative outlook on the EFSF’s (P)Aa1 rating reflects the negative outlooks on euro area sovereigns that are EFSF guarantors, including some countries with significant shares in the EFSF’s guarantor pool. Specifically, the Aaa ratings of Germany (which holds a 29.1% share in the guarantor pool) and the Netherlands (6.1%), as well as the Aa1 rating of France (21.8%) all have negative outlooks.
WHAT COULD MOVE RATINGS UP/DOWN
Risks that would negatively affect the creditworthiness of the ESM — leading to a potential further downgrade of the ESM’s rating — would include a deterioration in the creditworthiness of the participating euro area member states (as reflected by a change in Moody’s ratings for these states). In this context, the ESM’s rating is sensitive to changes in the ratings of Aaa- and Aa-rated countries with large ESM capital contribution keys, i.e., Germany, France and the Netherlands.
Furthermore, a weakening of the political commitment among euro area member states to the ESM could also have negative rating implications. Also, given that the ESM’s Aa1 rating is based on the assumption of superior financial-management capabilities, transition/downgrade risks could also arise from a potential erosion of those capabilities. Such risks would arise in the event of an inappropriate skill transfer or skill acquisition that might adversely affect ESM’s governance and risk management practice.
Given that the outlook on the ESM’s Aa1 rating is currently negative, the rating is unlikely to experience upward pressure in the near term. However, Moody’s could change the outlook for the ESM’s ratings to stable if the outlooks on the ratings of the highly rated countries that are key capital contributors to the ESM returned to stable.
Risks that would negatively affect the creditworthiness of the EFSF programme — leading to a potential downgrade of the EFSF’s rating — include a deterioration in the creditworthiness of the participating euro area member states (as reflected by a change in Moody’s ratings for these states). In this context, the EFSF’s rating is sensitive to changes in the ratings of Aaa and Aa countries with large EFSF contribution keys, i.e., Germany, France and the Netherlands. Moreover, as with the ESM, a weakening of the political commitment among euro area member states to the EFSF, as perceived by Moody’s, could also have negative rating implications.
Given that the outlook on the EFSF’s (P)Aa1 rating is currently negative, the rating is unlikely to experience upward pressure in the near term. However, the outlook on the EFSF’s ratings could return to stable if Moody’s decided to move to stable the outlooks on the ratings of highly rated countries with large EFSF contribution keys, i.e. Germany, France and the Netherlands.