Sunday, January 22, 2012

Eurozone’s Bailout Fund Suffers Credit Downgrade

FT: S&P Downgrades Eurozone Bail-out Fund
Reuters: Rescue Fund Downgrade Raises Pressure on Euro Zone
WSJ: S&P Cuts Rating on Europe's Bailout Fund
Telegraph: S&P cuts EFSF bail-out fund rating: statement in full

On Monday, the credit rating agency Standard & Poor’s lowered the credit rating of the Eurozone’s bailout fund, the European Financial Stability Facility’s (EFSF), one notch from its top AAA rating to AA+. The downgrade comes, in part, as a result of S&P’s decision on January 13th to lower the AAA ratings of France and Austria—two of the fund’s guarantors—as well as the Eurozone’s inability to adequately contain the region’s debt crisis. The fund still retains its AAA rating from credit agencies Moody’s and Fitch.

The EFSF’s main function is to safeguard financial stability in Europe by providing financial assistance to Eurozone countries. To do so, the EFSF issues bonds or other debt instruments on capital markets to raise the money necessary to lend to struggling Eurozone governments. The fund is backed by guarantees from Eurozone countries and derives its credit rating from the ratings of those countries. To maintain its AAA rating, the EFSF’s bonds could only be guaranteed by AAA rated countries. However, following the lowering of the ratings on France, Austria, and several other countries, the EFSF bonds are no longer fully supported by the guarantees of only AAA rated countries.

The credit downgrade of the EFSF could potentially lead to higher lending costs for countries borrowing from the EFSF. This is because the fund’s lending capacity would now have to be reduced (as there are fewer AAA guarantors) or the remaining AAA countries (such as Germany) would have to agree to increase the amount of their guarantees. However, Germany has already rejected raising its contribution to the fund, leaving the EFSF to attract investors by promising to pay higher premiums (return for the investor, but additional cost for the borrower). Nonetheless, last Tuesday, the EFSF managed to successfully sell its full target amount of €1.5 billion ($1.9 billion) of six-month bills at a yield of 0.2664% compared to a yield of 0.222% when it was rated AAA, signaling that robust demand still exists for ESFS debt.

Lastly, in an effort to increase the bailout fund’s lending capacity and effectively deal with the debt crisis, Eurozone leaders have accelerated the implementation of the European Stability Mechanism (ESM) (which will replace the EFSF as a bailout fund) to July 2012. The ESM differs from the current EFSF fund in that it is funded through paid-in capital provided by Eurozone countries, instead of just guarantees as with the EFSF. Also, the ESM would have a lending capacity of 500 billion euros—much larger than that of the EFSF. Thus, the ESM should offer lower lending costs since investors should be more willing to purchase bonds that are backed by capital rather than guarantees. In any event, the downgrade of the EFSF will make it more costly for troubled economies in the Eurozone to get financial aid and harder for the region to contain the debt crisis.

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