Fitch Affirms European Financial Stability Facility (EFSF)’s Debt Issues at ‘AAA’
Paris 05 December 2012
Fitch Ratings has affirmed the Long-Term rating of guaranteed medium and long-term debt issued by the European Financial Stability Facility (EFSF) at ‘AAA’, and the Short-Term rating of the short-term (less than 12 months contractual maturity) guaranteed debt instruments issued by the EFSF at ‘F1+’.
The rating assigned to the EFSF’s debt issues rely on the irrevocable and unconditional guarantees and over-guarantees provided by ‘AAA’ and ‘F1+’-rated euro area member states (EAMS). These commitments are governed by an international treaty signed in June 2010 by the 17 EAMS – the Framework Agreement – and by a Deed of Guarantee.
The original Framework Agreement and Deed of Guarantee ensured that all payments due on EFSF debt issues were covered by guarantees from EAMS pro-rata their share (contribution key) in European Central Bank (ECB) capital, adjusted for stepped-out guarantors, and over-guarantees (i.e. guarantees that could be extended up to 120% of their initial amount in the event of one or more guarantors stepping out of the pool of guarantors) rated ‘AAA’ or ‘F1+’, and by a cash reserve ensuring sufficient liquidity.
The amendment to the Framework Agreement and Deed of Guarantee made in June 2011, applicable to all debt issued since October 2011, reduced the cash reserve requirement for EFSF and extended the amount of over-guarantees by EAMS from 120% to a maximum of 165% of the initial guaranteed amount. This increased the aggregate amount of guarantees and over-guarantee to EUR726bn, and the maximum amount that EFSF can lend to EUR440bn (EUR726bn/1.65). As of end-November 2012, EFSF’s lending commitment stood at EUR188.3bn; this included loans and commitments to Greece (‘CCC’), Ireland (‘BBB+’; Stable) and Portugal (‘BB+’; Negative).
In addition to loans to EAMS under EU-IMF programmes, the June 2011 amended Framework Agreement has authorised the EFSF to conduct a wider range of financial assistance operations for EAMS including, loans to governments to fund recapitalisation of financial institutions outside macroeconomic adjustments programmes; purchases of sovereign bonds; and precautionary credit facilities. In contrast to EAMS receiving EFSF loans under an EU-IMF programme, EAMS are not expected to ‘step-out’ as guarantors in the event that they benefit from such financial assistance operations, though such support is subject to some policy conditionality as agreed under a memoranda of understanding.
While under the original framework agreement all loans had to be funded by debt of the same maturity, the June 2011 amendment has also allowed EFSF to issue short-term securities, implying a greater mismatch between the debt issued by the EFSF and the loans that it extends. Another amendment to the Deed of Guarantee has required EFSF’s short-term debt issuance to be covered by guarantees and over-guarantees from EAMS rated ‘F1+’, including guarantees from EAMS with a Long-Term rating below ‘AAA’, such as Belgium (‘AA’; Negative). This amendment allowed the reduction of the amount of the over-guarantee ratio to 151.7% for short-term debt issued by EFSF, versus 160.8% for long-term debt. Further flexibility was introduced by the February 2012 amendment to the Deed of Guarantee, which requires new debt issues to be covered by guarantees from EAMS having a rating equal or higher than that of EFSF, and not necessarily by EAMS rated ‘AAA’ or ‘F1+’.
The increase in the over-guarantee mechanism from 120% to up to 165%, in October 2011, has greatly reduced the cash reserves that the EFSF is required to hold in order to ensure that principal and interest on its debt was fully covered by ‘AAA’ guarantors and cash. The current requirement is for the cash reserve to be sufficient to service any debt payment at least three days prior to the payment date; in addition, 10 days prior to the servicing of debt, the cash reserve has to be at least equal to the share of the debt service payment not covered by ‘AAA’/’F1+’ rated guarantors or by EAMS having a rating equal or higher than that of EFSF. The cash reserve has to be conservatively managed, and has to be invested in high quality assets.
All EFSF debt issues are managed on its behalf by the German sovereign debt agency Finanzagentur (‘AAA’/Stable). Finanzagentur also undertakes treasury and risk management for the EFSF, while the European Investment Bank (‘AAA’/Stable) provides administrative and legal support. The high credit quality of these institutions considerably reduces operational risk associated with asset and liabilities management and treasury management.
The main source of credit risk on EFSF debt lies in the possibility that one or more of the largest ‘AAA’ guarantors fails to honour its guarantee commitment or is downgraded. In the event of a downgrade of Fitch’s rating of France (which represents 21.8% of guarantees), the Outlook on which was revised to Negative in December 2011, the ‘AAA’ guarantees and over-guarantees on outstanding EFSF debt would drop below the level consistent with the ‘AAA’ rating at the current lending capacity. Unless additional credit enhancement mechanisms are introduced, the ‘AAA’ rating of outstanding medium and long-term debt issued by the EFSF would thus be downgraded. The borrowing capacity of the EFSF would remain unaffected, but the ‘AAA’ Long-Term rating would only apply to medium and long term debt issues which are fully guaranteed by ‘AAA’ guarantees and over-guarantees, (and also by the cash reserve for debt issued before end-October 2011). Incorporated as a “Societe Anonyme’ in Luxembourg, the EFSF is a supranational financing vehicle created in 2010 to make loans to EAMS facing financing difficulties. It is part of a wider European and international initiative to support the eurozone, and benefits from broad political support.