S&P brought its hammer down on Europe today, with nine — count ‘em — downgrades of euro zone countries. The removal of France’s triple-A has been getting most of the headlines, but for me the bigger news is the fact that Portugal has now been downgraded to junk status.
Both of those moves, however, are pretty standard for ratings agencies in general and for S&P in particular: a slightly belated recognition of what has long been obvious to the rest of us. If anybody really thought that French sovereign debt was risk-free, or that Portugal, with its ten-year bond yielding somewhere north of 1,000bp north of Bunds, was investment grade, then they have surely been living under a rock for the past couple of years.
There’s one area, however, where S&P’s actions are going to have a significant and far from positive effect — and that’s the European Financial Stability Facility, or EFSF. The way that the EFSF is structured, its credit rating is particularly reliant on the ratings of the euro zone’s biggest sovereigns. Here’s how S&P put it back on December 6:
Based on EFSF’s current structure, were we to lower one or more of the current ’AAA’ ratings on EFSF’s guarantor members, all else being equal, we would lower the issuer and issue ratings on EFSF to the lowest sovereign rating on members currently rated ‘AAA’.
What this means is that Europe now faces a choice. On the one hand, it can restructure the EFSF so that it retains its triple-A credit rating. That would almost certainly involve shrinking the EFSF in size. Or, it can be sanguine about the EFSF downgrade and just let it happen. But that’s not a pleasant outcome either, given that everybody’s bright idea, when it comes to Europe’s sovereign bailouts, is to leverage the EFSF to some multiple of its present size. Leveraging a triple-A EFSF is hard enough; leveraging a double-A EFSF is pretty much impossible.
My guess is that the EFSF is going to get downgraded very soon — quite possibly on Monday. There’s actually not much point in Europe restructuring it so that it retains its triple-A: the political cost would be huge, and the benefit would be entirely hypothetical. (In theory, the financial markets are happy to lever up triple-A-rated assets. In practice, if those assets are European sovereign debt, not so much.)
Some small part of me thinks it’s a jolly good thing that the world is losing its store of triple-A assets. They’re dangerous things, precisely because we’re given to understand that they’re risk-free. But in this particular context, there are very few ways that today’s news can help Europe, and there are many, many ways that it can hurt. Not least when it comes to the amount of capital that Europe’s banks need to squirrel away against their stocks of sovereign debt.
Europe’s a risky continent; S&P is simply making that fact a little more obvious. In an ideal world, S&P’s opinions wouldn’t carry any more weight or importance than anybody else’s. But this isn’t an ideal world, and they do. And countries like France, which don’t control their own money supply, aren’t as immune to ratings-agency actions as the US turns out to have been.
The immediate ramifications of this announcement, in terms of global stock market reactions, aren’t important. And it’s even possible that if it accelerates the move away from the EFSF and towards the ESM, we could find a little bit of silver lining here. But the fact is that Europe is more fragile, now — more susceptible to changes in sentiment or genuine exogenous shocks — than it was yesterday. And that cannot be a good thing.