Downgrading Europe – What may be the real effects ?

Of course everyone was talking about the big downgrade action of Standard and Poors on Europe on Friday.

Lets look quickly at the downgrades themselves:

To From Austria (Republic of) AA+/Negative/A-1+ AAA/Watch Neg/A-1+
Belgium (Kingdom of) (Unsolicited Ratings) AA/Negative/A-1+ AA/Watch Neg/A-1+
Cyprus (Republic of) BB+/Negative/B BBB/Watch Neg/A-3
Estonia (Republic of) AA-/Negative/A-1+ AA-/Watch Neg/A-1+
Finland (Republic of) AAA/Negative/A-1+ AAA/Watch Neg/A-1+
France (Republic of) (Unsolicited Ratings) AA+/Negative/A-1+ AAA/Watch Neg/A-1+
Germany (Federal Republic of) (Unsolicited Ratings) AAA/Stable/A-1+ AAA/Watch Neg/A-1+
Ireland (Republic of) BBB+/Negative/A-2 BBB+/Watch Neg/A-2
Italy (Republic of) (Unsolicited Ratings) BBB+/Negative/A-2 A/Watch Neg/A-1
Luxembourg (Grand Duchy of) AAA/Negative/A-1+ AAA/Watch Neg/A-1+
Malta (Republic of) A-/Negative/A-2 A/Watch Neg/A-1
Netherlands (The) (State of) (Unsolicited Ratings) AAA/Negative/A-1+ AAA/Watch Neg/A-1+
Portugal (Republic of) BB/Negative/B BBB-/Watch Neg/A-3
Slovak Republic A/Stable/A-1 A+/Watch Neg/A-1
Slovenia (Republic of) A+/Negative/A-1 AA-/Watch Neg/A-1+
Spain (Kingdom of) A/Negative/A-1 AA-/Watch Neg/A-1+ N.B.–

This does not include all ratings affected.

I have already highlighted the changes which I consider as important and guess what- France is not important at all in my opinion.

The reason is very simple: In the “bond world, a downgrade from AAA to AA+ is pretty meaningless. Implied default rates are still extremely low for a AA+ rating, so most Credit risk models won’t punish a French bond due to this change. Also most portfolio managers will be quite indifferent between a AAA and AA+ rating since the US has been downgraded last year.

Much more critical is the situation for Portugal. With a non-investmeent grade rating, many bond portfolio managers will have to sell the bonds if they haven’t done already. Much worse, as the vast majority of bond mandates are restricted to investment grade (BBB- and better), many investors will be prohibited to invest in new Portugese bonds going forward. Due to the special “technique” of S&P called the “souvereign ceiling”,the same will apply for all Portugese companies. Per definition, the government ceiling sets the maximum rating for all companies based in that countries. Especially for the banks this will cut off ANY institutional business within Europe.The only solution there will be a takeover from a non Portugese bank.

For Italy, the downgrade to BBB+ and especially A-2 in the short term ratings will also impact the Italian companies. Due to the “sovereign ceiling” again, banks will struggle to externally refinance even more than in the past, as a A-2 short term rating will also basically shut them outof the unsecured short term market. However, as the unecured short term market barely exists anyway and it is still investment grade, the impact will be limited.

Finally, in the light of the other downgrades, i think for Ireland the constant rating should be at least some sort of benefit. Ireland is not really off the hook (negative outlook) but it should give them some breathing space in the near future.

In any case, one will have to wait for Moody’s to follow up. As long as for exapmle Portugal has one investment rating from Moody’s (“split rating”), the impact might be less severe than having actually two non-investment grade ratings. many fund mandates allow “split ratings” to a certain extent to remain in the portfolio.

Summary: In my opinion, the strongest impact of the downgrades will be felt in Portugal, where both, the government and the banks will have even more problems to fund themselves going forward. The downgrade of France is in my opinion more a “non-event” as the market doesn’t really care if a rating is AA+ or AAA these days after the US down grade.

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