AMERICAN FUTURE

I detect a somewhat more hopeful stance in this report on the eurozone’s prospects compared to earlier S&P reports. There’s more than a glimmer of hope in the report’s introduction:

The eurozone should gradually climb out of its mild recession in the second half of this year and into 2013, in Standard & Poor’s opinion. We think core countries will lead the way, with other member countries delivering diverging performances. Under our baseline forecast for 2012-2013, which we updated at the end of 2011, we project flat GDP for the eurozone as a whole in 2012 and 1% growth in 2013.

We acknowledge, however, that risks of a steeper downturn this year have risen. We currently assign a 60% probability to our baseline forecast, versus 40% for our alternative forecast of a true double dip, which would have a particularly adverse impact in countries like Spain, Portugal, and Italy. We believe three main factors will determine the depth of the eurozone’s downturn:

• How demand from emerging markets holds up in the coming quarters;
• How European consumers react to renewed uncertainties, such as rising unemployment and concerns about the sovereign debt crisis; and
• How European governments and especially the European Central Bank (ECB) rekindle investor confidence in capital markets in the next few quarters.

Still, we think the scale continues to tilt in favor of a mild recession and a gradual return to growth, taking into account potential growth in emerging market demand, resilient consumer demand in the core countries, and somewhat restored investor confidence.

This time, it raise a caution flag for the EFSF:

The ‘AAA’ rating on debt issues of the European Financial Stability Facility (EFSF) largely depends on France and Germany retaining their ‘AAA’ status. The revision of the rating Outlook on France to Negative last Friday implies that the risk of a downgrade of EFSF debt has increased.

We affirmed France’s ‘AAA’ status but warned that that there is a slightly greater than 50% chance of a downgrade within the next year or two. This is therefore also the case for the ‘AAA’ ratings assigned to the EFSF’s debt issues, unless additional credit enhancement mechanisms are introduced.

The ‘AAA’ ratings assigned to EFSF debt issues rely on the EUR726bn of irrevocable and unconditional guarantees provided by the euro member states, and on the conservative guidelines the EFSF sets itself regarding debt management and liquidity risk.

Of the guarantees and over-guarantees from ‘AAA’ rated member states, France and Germany provide EUR369.6bn, or over 80%. Although the EFSF could potentially remedy a downgrade of a small ‘AAA’ guarantor by increasing the size of its cash reserve or through additional credit enhancements, this would be far more challenging if a larger guarantor like France or Germany were downgraded. The primary source of ratings risk for EFSF debt issues is therefore the possibility that one or more of its largest ‘AAA’ guarantors is downgraded.

Because we do not assign Outlooks to the ratings of individual debt issues, but rather to our issuer ratings, the change in the French issuer rating Outlook cannot immediately be reflected in changes to our assessment of EFSF debt issues. We rate EFSF debt issues but not the EFSF itself, as it is the former rather than the latter that benefit from sovereign guarantees.

Under the amended Framework Agreement announced at the EU summit on 21 July, ‘AAA’ rated euro member states provide EUR451.5bn of guarantees and over-guarantees, giving the EFSF a maximum lending capacity of EUR440bn.

France is the most exposed of the ‘AAA’ euro member states to a further intensification of the eurozone sovereign debt crisis. It provides EUR158.5bn of guarantees plus over-guarantees to the EFSF guarantee pool under the framework agreement.

When we revised France’s rating Outlook, we noted that an increased likelihood that contingent liabilities arising from the crisis will be crystallised onto France’s balance sheet, material slippage from fiscal targets, and a re-assessment of France’s economic growth potential, could each trigger a rating downgrade. Conversely, economic and fiscal performance in line with our base case expectations, along with a resolution of the eurozone debt crisis, would be likely to result in a revision of the Outlook to Stable.

“Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.”

Fitch Affirms France at ‘AAA’; Outlook Revised to Negative

Fitch Ratings has today affirmed France’s Long-term foreign and local currency Issuer Default Ratings (IDRs) as well as its senior debt at ‘AAA’. Fitch has also simultaneously affirmed France’s Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’. The rating Outlook on the Long-term rating is revised to Negative from Stable.

The affirmation of France’s ‘AAA’ status is underpinned by its wealthy and diversified economy, effective political, civil and social institutions and its financing flexibility reflecting its status as a large benchmark euro area sovereign issuer. In addition, the French government has adopted several measures to strengthen the creditability of its fiscal consolidation effort. Nonetheless, government debt to GDP is currently projected by Fitch under its baseline scenario to peak in 2014 at around 92%, higher than any other ‘AAA’-rated sovereign with the exception of the UK and US and significantly higher than other ‘AAA’-rated Euro Area peers.

France’s sovereign credit profile benefits from a broad and stable tax base – the volatility of the revenue to GDP ratio is half the ‘AAA’ median – and the interest service burden is moderate and broadly comparable with other ‘AAA’s. Under Fitch’s baseline scenario that does not incorporate the realisation of substantial fiscal liabilities arising from the Eurozone crisis or other adverse shocks, even such an elevated level of government indebtedness is consistent with France retaining its ‘AAA’ status assuming that government debt is firmly placed on a downward path from 2013-14. The Negative Outlook on the French rating reflects Fitch’s view that the likelihood of the realisation of contingent liabilities, although still not our base-case assumption, has materially increased, as has the risk of a much worse than expected economic and consequently fiscal outturn.

Similar to other highly rated peers, France faces medium and long-term challenges to improve the functioning of the labour market and enhance international competitiveness. Fitch recognises that the authorities have adopted measures to address these weaknesses, though a more radical structural reform agenda would underpin greater confidence in the underlying potential growth rate of the French economy. However, corporate and especially household indebtedness is moderate compared to some ‘AAA’ peers, notably the UK and US, while foreign indebtedness remains modest, albeit rising.

The Negative Outlook is prompted by the heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone, as reflected in the Rating Watch Negative placed on the sovereign ratings of several Euro Area Member States (EAMS) on 16 December 2011. As Fitch commented in its report on 23 November, ‘French Public Finances’, the fiscal space to absorb further adverse shocks without undermining its ‘AAA’ status has largely been exhausted.

The intensification of the Eurozone crisis since July constitutes a significant negative shock to the region and to France’s economy and the stability of its financial sector. Since May, when Fitch last affirmed France’s ‘AAA’ status, its forecast for economic growth in 2012 has been cut from 2.1% to 0.7% with around one-in-four chance of outright contraction. Despite the additional fiscal measures announced in August and November equivalent to around 1% of GDP, further measures are likely to be required in order to cut the deficit to 3% of GDP by 2013 and stabilise government debt below 90% of GDP in light of the worsening economic and financial outlook.

In Fitch’s opinion, the commitments made by leaders at the EU Summit on 9-10 December and by the ECB were not sufficient to put in place a fully credible financial firewall to prevent a self-fulfilling liquidity and even solvency crisis for some non-AAA euro area sovereigns. In the absence of a ‘comprehensive solution’, the Eurozone crisis will persist and likely be punctuated by episodes of severe financial market volatility.

Relative to other ‘AAA’ Euro Area Member States, France is in Fitch’s judgement the most exposed to a further intensification of the crisis. It has a larger structural budget deficit and higher government debt burden relative to Euro Area ‘AAA’ peers. Moreover, relative to non-Euro Area ‘AAA’ peers, notably the US (‘AAA’/Negative Outlook) and the UK (‘AAA’/Stable Outlook), the risk from contingent liabilities from an intensification of the Eurozone crisis is greater in light of its commitments to the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), as well as indirectly from French banks that are less strong than previously assessed as reflected in recent negative rating actions by Fitch.

The Negative Outlook indicates a slightly greater than 50% chance of a downgrade over a two-year horizon. The triggers that would likely prompt a rating downgrade are as follows:

- Increased likelihood that contingent liabilities from an intensification of the Eurozone crisis will be crystallised onto the French state balance sheet.

- Material slippage from the fiscal targets that the government has set itself, notably the aim of stabilising the government debt to GDP ratio from 2013 and placing it on a firm downward path towards levels that would increase the ‘fiscal space’ necessary to absorb adverse shocks.

- Weaker than expected economic performance that prompts a re-assessment of France’s medium to long-term growth potential.

Conversely, economic and fiscal performance in line with Fitch’s baseline expectations, as set out in the Special Report, French Public Finances (23 November 2011), along with the resolution of the Eurozone crisis would likely result in the stabilisation of the rating Outlook.

In the absence of a material adverse shock, most likely associated with dramatic worsening of the Eurozone crisis, Fitch would not expect to resolve the Negative Outlook until 2013.

Fitch Places Belgium, Spain, Slovenia, Italy, Ireland and Cyprus on Rating Watch Negative

Fitch Ratings has placed the ratings of all investment grade rated eurozone sovereigns and their debt with Negative Outlook onto Rating Watch Negative (RWN). The euro area country ceiling of ‘AAA’ is unaffected. The rating actions are as follows:

- Belgium ‘AA+’/'RWN from ‘AA+’/Negative Outlook (‘F1+’ Unaffected)
- Spain ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Slovenia ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Italy ‘A+’/'F1′/RWN from ‘A+’/'F1′/Negative Outlook
- Ireland ‘BBB+’/'F2′/RWN from ‘BBB+’/'F2′/Negative Outlook
- Cyprus ‘BBB’/'F3′/RWN from ‘BBB’/'F3′/Negative Outlook

The RWN indicates that the above ratings are under active review and are subject to a heightened probability of downgrade in the near-term. Fitch expects to complete the review by the end of January 2012. If the review concludes that a downgrade is warranted, it is likely be limited to one or two notches.

Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach. Despite positive commitments by EU leaders at the Summit, notably the decision to accelerate the creation of the European Stability Mechanism (ESM) and to place less emphasis on private sector involvement (PSI), the concerns held by Fitch prior to the Summit remain pressing and have not been materially eased by the Summit outcome (also see, ‘Summit Does Little To Ease Pressure on eurozone Sovereign Debt,’ 12 December). Of particular concern is the absence of a credible financial backstop. In Fitch’s opinion this requires more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent Euro Area Member States (EAMS).

Fitch recognises that the policy authorities in all of the countries with sovereign ratings subject to review have embarked upon significant fiscal consolidation and structural reform and these efforts will be taken into account in the review. However, the systemic nature of the eurozone crisis is having a profoundly adverse effect on economic and financial stability across the region and for some EAMS poses near-term risks that are beginning to dominate the sovereign-specific risk fundamentals. Today’s announcement is focused on those sovereigns that are potentially vulnerable to the worsening external economic and financial environment as indicated by previous negative rating actions and rating Outlooks.

The RWN is prompted by the following risk factors:

- In the absence of greater clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union and the recognition by political leaders of the potential for an EAMS to leave the eurozone, Fitch will review its assessment of the balance of risks associated with eurozone membership, especially for sovereigns potentially subject to funding stresses.

- While acknowledging the extraordinary measures the ECB has adopted to provide liquidity to the European banking sector, its continued reluctance to countenance a similar degree of support to its sovereign shareholders undermines the efforts by EAMS to put in place a credible financial ‘firewall’ against contagion and self-fulfilling liquidity and even solvency crises.

- The intensification of the eurozone crisis since July constitutes a significant negative shock to the region’s economy and the stability of its financial sector with potentially adverse consequences for sovereign credit profiles across the region, most immediately for those placed on RWN today.

- In the absence of a ‘comprehensive solution’, the crisis will persist and likely be punctuated by episodes of severe financial market volatility that is a particular source of risk to the sovereign governments of those countries with levels of public debt, contingent liabilities and fiscal and financial sector financing needs that are high relative to rating peers.

In light of these heightened risks, Fitch will re-consider the assumptions and analysis that underpin its current sovereign ratings of Belgium, Slovenia, Spain, Italy, Ireland and Cyprus to ensure that the above risk factors are appropriately reflected in its sovereign ratings in accordance with its sovereign rating methodology.

The focus on investment grade rated sovereign governments with Negative Outlooks reflects previous research and analysis that indicates specific weaknesses that render them especially vulnerable to the intensification of the eurozone crisis. However, the outcome of the review will also incorporate Fitch’s current assessment of the strength of their underlying economic and credit fundamentals as reflected in their current sovereign ratings as well as recent policy measures adopted at the national level.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

As everyone who pays attention to financial matters knows by now, S&P this afternoon put 15 eurozone governments on “CreditWatch With Negative Implications.” Click here for the details of its sovereign rating actions.

More interesting to me are two posts in the FT Alphaville blog that expand upon a section (beginning on page 61) of the Credit Suisse 2012 Global Outlook report.  I addressed the first post earlier today. The second Alphaville post (“S&P plays Grim Reaper for the upcoming death of AAA“) was published after S&P issued its warnings:

[By warning governments that their ratings could be lowered] S&P surely also questions the AAA future of the EFSF. Many will also question the timing of any S&P announcement, coming shortly after Merkozy’s latest deal and with the “crucial” European summit a few days away. But…

Why is this (long overdue) realisation important? For one thing, as noted on FT Alphaville earlier on Monday, the universal pool of ‘risk-free’ investments has been contracting since 2008 anyway:

That in turn has caused a major run on the few remaining ‘safe assets’ out there.

A situation which in itself has fueled record low yields and negative repo rates on quality collateral, but rising yields, repo rates and hair cuts on ‘unsafe collateral’. Collectively, the two phenomena have choked up access to cheap secured funding. Regulatory moves to increase the amount of ‘quality collateral’ held unencumbered on banks’ balance sheets, as well as a general move towards central counterparty (CCP) trading relationships — all of which require more pledged collateral — have hardly helped to ease the collateral crunch.

Without enough ‘quality collateral’ to go round, some governments have even turned to synthetic alternatives to try and fill the gap.

But what does the end of risk-free really mean in this context?

We’d say the fact that there is no such thing as a principal protected investment anymore — no matter how pronounced the dash for the underlying security itself is. One way or another, the investor is now prepared for the fact that he may lose principal — either as a result of gambling in risky securities, or by paying a charge to be invested in less risky securities. [My emphasis]

You could say, the investment world has gone from a world of absolutes to a world of relative investments as and how they compare to cash deposits.

If you want to ensure that you’ll get your money back over time, you now have to pay up for the privilege of doing so via a possible negative yield. It’s the de facto depreciation of money in play. There’s no such thing as a safe investment and you can’t expect an interest rate unless you take a sizeable risk. [My emphasis]

On a relative scale, it doesn’t really matter which debt investment is considered the safest.

The difference between negative yielding debt and positive yielding debt is now about the difference in risk perception. The first sees the investor knowingly erode his wealth for the privilege of investing in the safest asset out there, the second sees the investor chance his wealth for the privilege of receiving a yield.

The first allows an investor to offset the wealth erosion effect via a lending fee, since the cash he receives can only be invested with exposure to greater risk. The second expects the investor to compensate the market (via a larger haircut payment) for the greater risk associated with lending cash against ‘unsafe assets’.

In the first, the investment is considered safer, or as safe, as cash deposits (after national insurance costs are factored in), while in the second, the investment is considered much riskier than cash deposits alone.

The riskier the asset, the larger the haircut.

Both, nevertheless, see cash unwittingly re-collateralised. Too much cash relative to existing collateral equals a natural contraction and what might be described as a self-enforced move towards negative rates in assets perceived to hold value, against a self-enforced move towards higher rates (and haircuts) in assets deemed likely to depreciate.

Sure sounds like 1930s-style deflation to me.

European governments, which have already had it “up to here” with credit rating agencies, are undoubtedly more than a little displeased with today’s announcement from Moody’s. Here’s the press release:

The continued rapid escalation of the euro area sovereign and banking credit crisis is threatening the credit standing of all European sovereigns . . . In the absence of policy measures that stabilise market conditions over the short term, or those conditions stabilising for any other reason, credit risk will continue to rise . . . amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. While the euro area as a whole possesses tremendous economic and financial strength, institutional weaknesses continue to hinder the resolution of the crisis and weigh on ratings. In terms of the policy framework, the euro area is approaching a junction, leading either to closer integration or greater fragmentation.

While Moody’s central scenario remains that the euro area will be preserved without further widespread defaults, even this ‘positive’ scenario carries very negative rating implications in the interim period . . . the political impetus to implement an effective resolution plan may only emerge after a series of shocks [note that, in light of the supercommittee's failure, the same could be said about the US], which may lead to more countries losing access to market funding for a sustained period and requiring a support programme. This would very likely cause those countries’ ratings to be moved into speculative grade in view of the solvency tests that would likely be required and the burden-sharing that might be imposed if (as is likely) support were to be needed for a sustained period.

However, over the past few weeks, the likelihood of even more negative scenarios has risen. This reflects, among other factors, the political uncertainties in Greece and Italy, uncertainty around the final haircut imposed on holders of Greek debt, the emphasis in the recent Euro Summit statement on the conditional nature of the existing support programmes and the further worsening of the economic outlook across the euro area. Alternative outcomes fall into two broad categories: those involving one or more defaults by euro area countries (in addition to Greece’s PSI programme); and those additionally involving exits from the euro area.

The probability of multiple defaults (in addition to Greece’s private sector involvement programme) by euro area countries is no longer negligible. In Moody’s view, the longer the liquidity crisis continues, the more rapidly the probability of defaults will continue to rise.

A series of defaults would also significantly increase the likelihood of one or more members not simply defaulting, but also leaving the euro area. Moody’s believes that any multiple-exit scenario — in other words, a fragmentation of the euro — would have negative repercussions for the credit standing of all euro area and EU sovereigns.

Moody’s notes that the situation is fluid and fast-moving. Policymakers are likely to respond to the escalating risks with new measures, the credit implications of which will require careful consideration. In the meantime, new shocks to financing conditions — whether the announcement of new programmes or simply a further acceleration in the rise of funding cost across the euro area — are likely to lead to selective rating changes. More broadly, in the absence of major policy initiatives in the near future which stabilise credit market conditions, or those conditions stabilising for any other reason, the point is likely to be reached where the overall architecture of Moody’s ratings within the euro area, and possibly elsewhere within the EU, will need to be revisited. Moody’s expects to complete such a repositioning during the first quarter of 2012.

And here’s the complete report:

From Global Macro-Risk Outlook 2011-2012: Material Slowdown in Growth (Published November 11)

The material slowdown in the recovery from the 2008-09 global financial crisis and recession has prompted us to revise downwards our growth forecasts for most G-20 economies. Overall, we now expect real growth in these economies to be around 3.1% in 2011 compared with our earlier forecast of 3.7%, and around 3.2% in 2012 compared to 4.0% previously.

Financial market volatility stemming from the escalation of the debt crisis in the euro area and accompanying the US fiscal outlook discussions earlier in the year have affected consumer and business confidence. Combined with ongoing deleveraging efforts in the public and private sectors, persistently high unemployment levels and real estate market weaknesses, these developments have resulted in a material slowdown in advanced economies. We expect that financial market turbulence, fiscal consolidation efforts and banking sector deleveraging will continue to constrain growth into 2012.

The slowdown in advanced economies is in turn triggering a reversal of international capital flows to a number of emerging market economies and a deceleration of world trade. We expect the economic slowdown to spill over into emerging markets. The impact on individual countries and regions will vary: Emerging Europe will be most directly affected by the turmoil in euro area financial markets, while Asia and Latin America will be relatively resilient. There is a significant downside risk to our forecasts for the euro area. We believe that there is a high risk of a euro area recession (defined as two consecutive quarters of negative growth). While the recently announced package of measures provides temporary liquidity relief for sovereigns and banks in the area, the medium-term strategy for addressing the underlying macro-economic anddebt affordability challenges – which remains reliant on fiscal consolidation and competitivenessmeasures to foster growth – is subject to significant implementation risks. Furthermore, the precedent being set with a default in the form of Private Sector Involvement (PSI) haircuts in Greece represents a structural break in the funding costs for stressed or potentially stressed euro area countries. This leaves euro area sovereign and bank credit markets prone to disruption. Additionally, the rising funding pressures and the increased capital requirements for banks are likely to exacerbate the credit contraction already underway.

From A Challenge at the Wrong Time: European Bank Financing Needs Are Set to Peak as Market Conditions Worsen (Published November 10)

While much attention has been paid to the challenges many European banks will face in boosting their capital bases, there has been much less focus on their need to refinance their large volumes of obligations that will mature in the coming months — a time when we expect market conditions to remain difficult. European banks have reacted to wide bond and CDS spreads by limiting issuance: in the year to date, they raised only $200 billion in the capital markets.

Of course, banks have many ways of mitigating their refinancing risk, amongst them shrinking their balance sheets. This is not good for European economic growth, which is another story. Regardless, we think continuing the issuance avoidance strategy will be less tenable in the coming months, when European institutions face a massive level of debt maturity, much of it relatively short-dated government guaranteed debt issued in 2008 and 2009.

European banks have $700 billion in public market debt scheduled to mature over the next nine months compared to $921 billion for the past 18 months. This represents a prospective average quarterly run rate of $230 billion compared to a recent average of $153 billion. The word “scheduled” provides an important caveat — some of the obligations could well have been already been refinanced. Whatever the actual amount coming due between now and next June, the magnitude of the increased amount remains significant.

Aside from shrinking their balance sheets, banks can also mitigate their bond rollover risk by seeking other sorts of funding. However, these options are more constrained than they might first appear to be. Deposits are usually the cheapest source of funds, but stiff competition for them means that “new” deposits for each bank will only available to the system via major banking sector consolidation, strong economic growth, or significant monetary expansion.

As noted, another option for banks to meet the June 2012 9% capital targets3set by the regulators would be to shrink their balance sheets by shedding assets. This could prove problematic. On average, European bank equities are trading at approximately 50% of their stated book value, indicating that there is not a deep market for their assets at their carrying costs.

From European Sovereign and Banking Crisis (Published November 14)

Last Monday’s €3 billion, 10-year bond issuance by the European Financial Stability Facility (EFSF) was met with significantly less demand than a similar bond issuance on 15 June, and priced at 177 basis points (bps) over 10-year German Bunds, versus 51 bps in June. Investors’ cool reaction to proposals to leverage the EFSF’s lending capacity (through partial default insurance and/or a special-purpose vehicle, or SPV) contributed to the weak demand, although fundamentally, these leverage options will not affect the EFSF’s creditworthiness. Both the pricing of the EFSF’s last issuance, and the lack of progress in leveraging its lending capacity, display the limits of the EFSF’s ability to support European government bond markets.The rise in EFSF spreads is an important signal because it reflects a rise relative to the spreads of its Aaa-rated guarantors. In theory, EFSF spreads should be below the weighted average spread of its Aaa-rated guarantors, since EFSF issuance is 100% covered by guarantees from Aaa-rated sovereigns and also benefits from guarantees from non-Aaa-rated member states and from the underlying borrower’s repayment obligation.

. . . this development calls into question the ability of the EFSF to fund itself in the markets at low cost. The success of the EFSF as a tool to stabilize sovereign debt prices and the success of the current euro area-wide support mechanism comes into doubt if that ability is compromised. These concerns are amplified by a lack of progress on the two proposed leverage options as investors remain reluctant on both partial default insurance and an SPV. Against the backdrop of the proposals on Greek private sector involvement, investors expect that the suggested 20% protection (either by collateral or by an equity tranche in the SPV) will not necessarily cover them in case of a default. As a consequence, the proposals are unlikely to generate significantly greater demand for euro area sovereign debt. With its current lending capacity (which is at about €266 billion considering commitments to Ireland, Portugal and Greece), the EFSF cannot meaningfully support the euro area’s large government bond markets. This limits the EFSF’s role as an important pillar of the euro area crisis management strategy.

CNBC says that the release of this report on the European exposure of U.S. banks is what caused the equity market to weaken this afternoon. An excerpt:

Fitch believes that, unless the eurozone debt crisis is resolved in a timely and orderly manner, the broad outlook for U.S. banks will darken . . . The risks of a negative shock are rising and could  alter Fitch’s stable rating outlook for U.S. banks . . . Any prolonged turmoil could negatively affect capital market-related revenues well into the future, not to mention the possible effects on loan portfolios and other revenue opportunities.

. . . Ratings of U.S. banks could be pressured if difficulties in Europe, combined with domestic economic challenges, result in significant incremental revenue pressure, combined with a reversal of positive asset quality trends. U.S. banks have been reporting improving asset quality in 2010 and to date in 2011. This positive trend could change course if contagion effects translate into a slowdown in general economic activity. The U.S. economy already faces continued pressure on real estate and persistently  high unemployment, combined with fiscal pressures at the government level.

How insightful! If this was enough to send the market south, the equity market is on very shaky gound.