Crisis in the Eurozone: The Reality of the European Downgrades

It turned out to be a ruinous Friday the 13th for Europe last week.

After the close, Standard & Poor's downgraded nine of the sovereign states in the European Union (EU).

That included dropping Austria and France to AA+ status from their formerly lofty AAA rating.

While the decision was expected, and will most likely be followed by additional downgrades from the other rating agencies such as Moody's Corp. (NYSE: MCO) and Fitch Ratings Inc., it's the knock-on effects that will have larger implications for investors around the world.

In the Wake of the European Downgrades

The first and most obvious effect was the downgrade of the European Financial Stability Facility (EFSF) that followed on Monday. In the wake of Friday's bad news, the EFSF was also dropped to a AA+ rating.

According to the S&P:

"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

The S&P also warned more EFSF downgrades would follow if the ratings of other individual states dropped in the future.

In a warning the EFSF could fall below AA+ the S&P said:

"Conversely, if we were to conclude that sufficient offsetting credit enhancements are, in our opinion, not likely to be forthcoming, we would likely change the outlook to negative to mirror the negative outlooks of France and Austria. Under those circumstances we would expect to lower the ratings on the EFSF if we lowered the long-term sovereign credit ratings on the EFSF's 'AAA' or 'AA+' rated members to below 'AA+'."

So where do we go from here?

Why the EFSF Downgrade Looms Large

It's my expectation that the downgrade of the EFSF will have a larger overall impact than the individual ratings downgrades that occurred on Friday the 13th.

The EFSF was supposed to provide $440 billion in emergency funding to states in need of liquidity but were unable to access the capital markets at prices they could pay.

While no one was willing to publicly call the EFSF a bad bank, because it wasn't issued a banking charter, it was set up as a special investment vehicle (SIV) to handle the arbitrage between AAA bonds in Europe and A-like rates demanded by market participants.

In simple terms, the EFSF was expected to be able to issue cheap debt, which it would use to buy up sovereign debt at fixed rates below what the individual states could get on their own.

The problem is the downgrade will increase the cost of issuing debt at the EFSF, which will mean that its main reason for existing will be nullified by the market. In other words, the debt it issues will be less cheap.

As a non-sovereign, non-bank investment vehicle with less than a AAA rating, I believe the EFSF will find a serious lack of interest in its issuing debt.

In fact, the lack of demand for its debt - even with a AAA rating - was already a joke among market professionals.

Now with a lack of AAA support left in Europe to cover its guarantee commitments, I don't believe the EFSF will ever play a major role in stabilizing Europe.

Europe's Only Real Life Line

The S&P said in its announcement that it would consider upgrading the EFSF to AAA again if the national commitments were increased.

However, this upgrade path back to AAA was quickly damaged by Wolfgang Schaeuble, the finance minister of Germany, who made it very clear Germany did not plan on adding to its EFSF commitments.

"It is sufficient," Schaeuble told Deutschland Radio. "The guarantee sum that we have is sufficient by far for what the EFSF has to do in coming months."

That means Europe's only real lifeline now is the International Monetary Fund (IMF), which will supersize the capital base and bail out the whole continent when the needed bank recapitalizations happen.

While the EFSF downgrade has garnered a lot of near-term economic focus, the reality now is that Europe needs to work on its Union structure if it plans on regaining a path towards organic growth.

News and Related Story Links:

• Standard & Poor’s:
  
  Press Release on EFSF downgrade.
• Money Morning:
  Should You Worry About Europe's Back Door Bank Run?
• Money Morning:
  European Bond Traders Are Going For the Jugular
• Money Morning:
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