Euro Area Economics

11 December 2011

Implications of S&P downgrades

France loses it and so does Austria
The market implications of the ratings review are worse than a whole downgrade of the region owing to the increased political wrangling, questions on the EFSF/ESM firewall and the fact that flight to quality still has somewhere to go. Germany comes out as a clear winner and will have its position at the negotiating table strengthened even further. The French downgrade will complicate future negotiations around fiscal integration and comes at a delicate time domestically. The loss of the AAA is likely to be politicised in the run up of the upcoming general elections and could lead to an increase in popular support for fringe parties. S&P made its long awaited announcement since placing 15 euro area sovereigns on CreditWatch with negative implications in early December. Despite warning of the potential for a blanket downgrade of all sovereigns (apart from Greece, which is already rated CC), S&P have instead taken a more selective approach. The ratings of seven countries were left unchanged (Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, the Netherlands), while there were one notch downgrades for five countries (Austria, France, Malta, Slovakia and Slovenia). Two notch downgrades were given to four countries (Cyprus, Italy, Portugal and Spain). The new ratings and changes are shown below. All countries were removed from CreditWatch, but 14 countries have negative outlooks (the only exceptions being Germany and Slovakia), indicating that S&P see at least a one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon for investment grade countries is up to two years, but only up to one year for speculative-grade ratings. Greece was not part of this exercise and remains CC with negative outlook. S&P assigned a recovery rating of 4 to Cyprus and Portugal (as they moved into speculative-grade category), indicating an expected recovery of 30-50% should a default occur. Overall, the most notable outcome was the clear differentiation between Germany and all other AAAs countries. Germany comes out as a clear winner with a stable outlook. The French downgrade comes at a d time and will likely complicate domestic politics ahead of the critical general elections. Likewise, Frances position at the European negotiating table is likely to be weakened vis--vis Germany. This might render future negotiations surrounding fiscal integration even more difficult. As was anticipated, S&P mentioned that the key rationale behind the downgrades was the lack of decisiveness and effectiveness in the European policy response. The criticism seems to be aiming at the lack of firepower of the fiscal backstops rather than the ECB itself which was praised for its actions. In this context, it is rather surprising that the treatment of EMU solidarity contingent liabilities was quite different between countries, with the harshest words for France and not even a mention for the other AAAs including most surprisingly Germany. Other factors mentioned relate to the risk of further fiscal deterioration.

Analysts
Jacques Cailloux Chief European Economist +44 20 7085 4757 jacques.cailloux@rbs.com

Nick Matthews Senior European Economist +44 20 7085 0173 nick.matthews@rbs.com

Michael Michaelides Covered Bond/Agency Strategist +44 20 7085 1806 michael.michaelides@rbs.com

Harvinder Sian Rates Strategist +44 20 7085 6539 harvinder.sian@rbs.com

Frank Will Head of Covered Bond Research +44 20 7085 2091 frank.will@rbs.com

www.rbsm.com/strategy Bloomberg: RBSR<GO>

Important disclosures can be found on the last page of this publication.

Although Euro area member states will explore the options to keep the EFSFs tripleA, we expect S&P will ultimately align the EFSFs rating with that of France and Austria at AA+. Indeed, in order to maintain the AAA rating of the EFSF, euro area policy makers would have to accept a reduction in the lending capacity of the EFSF by Eur169bn. Alternatively they would need to increase their guarantees significantly, something we believe unlikely at a time that the focus is shifting on the ESM. The upcoming ESM will however also face a difficult trade-off between higher lending volume and achieving a AAA rating. With no further increase to the current callable capital levels, the lending capacity of the ESM would decline by Eur200bn. To maintain the current lending capacity and its AAA, then member countries would need to double their level of callable capital into the ESM compared to current commitment. Should euro area policy makers want to double the lending capacity of the ESM from pre downgrade times (while maintaining its AAA), then the ESM would need a callable capital of almost 30% of euro area GDP! Discussions surrounding the potential increase in the size of the ESM in March will be more difficult post downgrade. The EIB and EU will most likely be able to avoid a downgrade, with the latter having a higher likelihood of a rating confirmation. A negative outlook, particularly in the case of EIB, cannot be ruled out however. We are alert to a more muted market impact near term by domestic buying (France) and ECB buying (Italy/Spain) but the negative rating outlooks (ex-Germany and Slovakia) means risks can quickly return. For instance, the downgrade for France and Austria will mean technical shifts into better rated markets for collateral purposes. The Austrian downgrade was not consensus but more generally the negative market outlook for France also hurts. Italy faces similar collateral demand weakening, and this continues a trend. The general EGB flow is buying in domestic markets and buying safety/liquidity and France will lose some traction on this score and since most of the debt in EMU is held by EMU residents (and can not be shifted out of Euros wholesale) then Bunds will see increased structural support towards that will keep short end yields negative and gradually support our (still) bullish view on German bonds. We reiterate that the German bond view is not the same as a view on the German credit given the flow of funds. Italys move to a BBB+ means it is now much closer to Junk status and we agree with S&P in that austerity is likely to be self-defeating and political risks remain high. Overall, while the market impact of the downgrades is unlikely to be very significant in the short term, they serve as a stark reminder that the euro area sovereign crisis is here to stay. More importantly, these downgrades are likely to solidify expectations that neither the EFSF nor the ESM will be able to maintain their AAA rating. This in turn is likely to make any significant increase in the lending capacity of either institution more difficult. We continue to expect the crisis to deepen eventually leading to further widening in spreads across countries vis--vis Germany.

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Euro area S&P ratings

Euro area Old S&P country rating Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain AAA AA BBB AAAAA AAA AAA CC BBB+ A AAA A AAA BBBA+ AAAAS&P possible downgrade limit (5th Dec) 1 notch 1 notch 2 notch 2 notch 1 notch 2 notch 1 notch 2 notch 2 notch 1 notch 2 notch 1 notch 2 notch 2 notch 2 notch 2 notch Actual downgrade 1 notch unchanged 2 notch unchanged unchanged 1 notch unchanged unchanged 2 notch unchanged 1 notch unchanged 2 notch 1 notch 1 notch 2 notch New S&P rating AA+ AA BB+ AAAAA AA+ AAA CC BBB+ BBB+ AAA AAAA BB A A+ A Outlook Grade

Negative Negative Negative Negative Negative Negative Stable Negative Negative Negative Negative Negative Negative Negative Stable Negative Negative

Investment Investment Speculative Investment Investment Investment Investment Speculative Investment Investment Investment Investment Investment Speculative Investment Investment Investment
Source: S&P, RBS

Only four AAA countries in the euro area remain on the S&P methodology (Germany, the Netherlands, Finland and Luxembourg). While undoubtedly good news for these countries, we view the decision to not apply a wholesale downgrade to all countries as the worst possible outcome from a euro area crisis management perspective and might contribute to shift euro investors into Germany and away from the EFSF and France. Absence of a wholesale downgrade a surprise to us While some of the downgrades are unsurprising, our core view was a wholesale downgrade to all countries given that S&P was highlighting system-wide stresses stemming from interrelated factors such as: (i) tightening credit conditions across the euro area, (ii) markedly higher risk premiums on a growing number of sovereigns, including some that were rated AAA, (iii) continuing disagreements among euro area policymakers on how to tackle the crisis and ensure greater economic, financial, and fiscal convergence among euro area members, (iv) high level of government and household indebtedness across a large portion of the euro area, and (v) the risk of recession in the euro area this year. In our post-EU Summit assessment in December (Where is the Fiscal Union?, 11 December 2011), we wrote: We see the next leg of this crisis as potentially being triggered by wholesale rating downgrades by rating agencies as they become (i) increasingly convinced that a recession is inevitable, (ii) the ECB will not QE the system, (iii) the leaders are too slow to make the quantum leap into the fiscal union. We covered extensively our thoughts over the chain reaction that could follow from a wholesale downgrade of euro area members in Where is the Fiscal Union?, noting at the time it was a scenario which we now believe to be very likely. We stated at the time that the ramifications of such a decision by S&P, potentially to be followed in Q1 by Moodys, would be far reaching with supra national organisations such as the World Bank at risk of downgrades. To complement this note, we also encourage clients to re-read Section 3 Multiple Sovereign downgrades are likely in Where is the Fiscal Union?, where we covered in

Implications of S&P downgrades| 11 December 2011 Page 3

detail the implications of downgrades for Supras & Agencies and Government Guaranteed Debt, the impact on euro area banks and the transmission channels of sovereign downgrades into banks. In this note we focus on (i) S&Ps motivations for its ratings actions, (ii) implications of the ratings downgrades on the EFSF, (iii) ESM, (iv) the negotiating power between France and Germany, (v) the market impact of ratings downgrades, and (vi) the impact on European supranationals.

1. S&Ps motivations for its ratings actions

S&P noted that its ratings actions were primarily driven by its assessment that policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. The stresses were said to include: (i) tightening credit conditions, (ii) an increase in risk premiums for a widening group of eurozone issuers, (iii) a simultaneous attempt to delever by governments and households, (iv) weakening economic growth prospects and (v) an open and prolonged dispute among European policymakers over the proper approach to address challenges. S&P remain unimpressed by the outcome of the EU Summit and subsequent policymaker statements and lead S&P to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozones financial problems. In particular, S&P noted its opinion that the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures. There was criticism of a reform process based on fiscal austerity alone which it said risked becoming self-defeating. S&P stated refinancing costs for certain countries may remain elevated, credit availability and economic growth may further decelerate and pressure on financing conditions may persist. Therefore, external scores were adjusted down for sovereigns considered most at risk of an economic downturn and deteriorating funding conditions (eg. due to large cross-border financing needs). Interestingly, S&P made clear that the ratings downgrades were not caused by any inaction by the ECB. On the contrary, S&P said the ECB had been instrumental in averting a collapse of market confidence. They highlighted the ECBs easing of collateral requirements, an ever expanding collateral pool, the lowering of interest rates to an all-time low of 1% and most importantly in our view, it has engaged in unprecedented repurchase operations for financial institutions, greatly relieving the near-term funding pressure for banks. However, S&P warned that while it currently assessed the ECBs response as broadly adequate it said our view could change as the crisis and the response to it evolves. It warned a lowering of the monetary score for all eurozone sovereigns could have negative consequences for the ratings on a number of countries. Sovereigns with unchanged ratings (Bel, Est, Fin, Ger, Ire, Lux, Neth) S&P highlighted these seven countries are likely to be more resilient in light of their relatively strong external positions and less leveraged public and private sectors. These credit strengths were said to remain robust enough to neutralise the potential ratings impact from the political problems noted above. Sovereigns with negative outlooks (all except Germany and Slovakia) S&P believe downside risks persist and a more adverse economic and financial environment could erode their relative strengths within the next year or two to warrant further downward revision. The main downside risks affecting sovereigns to various degrees are related to the possibility of further significant fiscal deterioration as a

Implications of S&P downgrades| 11 December 2011 Page 4

consequence of a more recessionary macroeconomic environment and/or vulnerabilities to further intensification and broadening of risk aversion among investors, jeopardizing funding access at sustainable rates. S&P also warned that a more severe financial and economic downturn it expected could also lead to rising stress levels in the banking system, potentially leading to additional fiscal costs for the sovereign through bank workout/recapitalisation programmes. Furthermore, it also highlighted a risk that reform fatigue could be mounting, especially in countries with deep recessions and where growth prospects remain bleak, which S&P said could eventually lead us to the view that lower levels of predictability exist in policy orientation.

Overview of downside ratings triggers for S&P, covering major EGB issuers that were on ratings watch negative previously
Primary downside drivers to S&P ratings Stable outlook reflect robust public finances/prudent budgets. Downside risk if net govt debt/GDP moves to 100% from 80% Downside risk from unexpected surge in contingent liabilities from domestic financials. It curiously does not reference extra EMU solidarity contingent liabilities. Negative outlook based on deviation of budgets from a consolidation path and announced measures may be insufficient if growth falters, and net govt debt/GDP moves to 100% from 80% Downside risk if heightened financing & economic risks in EMU lead to a significant rise in contingent liability or a material widening in external financing conditions. (This looks harsher than German/Dutch/Finnish risk on contingent liability.) Negative outlook if public finances deviate in a significant and sustained way from the 2012-15 plan due to a prolonged decline in growth. If the government net borrowing exceeds 3% per year over the medium term No reference to extra EMU solidarity contingent liabilities or financial sector contingent liabilities Negative outlook given risks Austrian banks' balance sheets from negative developments in major trading and outward direct investment partners such that Austrian government needed to recapitalize the banks. This could lead to net general government debt rising above 80% of GDP, and could also further increase contingent liabilities. Economic growth is much weaker S&P expect which could undermine budget consolidation and render structural reforms ineffective, and see an increase in net general government debt beyond 80% of GDP. No reference extra EMU solidarity contingent liabilities. Negative outlook based on any sustained current account deficits or sustained deviation in public finances from the planned budgetary consolidation path for any reason. S&P references sustained net new borrowing of 2.5% GDP a likely to trigger a downgrade. No reference extra EMU solidarity contingent liabilities. Negative outlook based on delays in additional labour market and other growth enhancing reforms, or if the reforms are deemed in sufficient. The government does not undertake additional measures to broadly meet 2012 and 2013 of 4.4% and 3% respectively. Further pressure from the private sector leads to a reassessment of sovereign fiscal performance, particularly if it results in an increased need for additional capital injections from the state or similar interventions. Negative outlook on weaker-than-expected macroeconomic environment and deflationary pressures that reduce Italy's per capita GDP; and result in Italy's net government debt ratio continuing its upward trajectory. Or else, on a prolonged worsening of financing conditions. If the technocratic administration fails to implement necessary structural reform measures (that boost growth) whether on opposition from special interest groups, other incumbents or if the government's term is cut short before the mandate is fulfilled. No mention here on additional financial sector contingent liabilities.. Negative outlook on a more severe economic contraction resulting in worsening political environment and further negative adjustment in the S&P political score. In particular, continued fiscal austerity without improving growth prospects could result in widespread unemployment, which could negatively affect social cohesion & political support for the EU/IMF program. If potential cost of recapitalizing Portuguese banks is likely to increase government debt burdens substantially.. Negative outlook if weaker external demand results in lower economic growth undermining the government's strong policy implementation. If this was not offset by redoubled efforts to attain fiscal consolidation targets the S&P political score could be lowered.
Source: RBS

Germany

France

Netherlands

Austria

Finland

Spain

Italy

Portugal

Ireland

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2. Implications for the EFSF

Back in July 2011 we stated that the biggest hurdle to a significant upsizing of the EFSF was the implication of the contingent liabilities for AAA sovereign ratings: Net/net, there are problems with upsizing the EFSF or ESM in terms of the size of the contingent liability and the ratings threat to AAA countries and the EFSF itself. If any of the large AAA countries is downgraded, then the EFSFs own AAA rating will also be severely threatened and its lending capacity will be curtailed. (Euro area faces break point | Lessons learned and policy options, 13 July 2011). We also warned more recently (Where is the Fiscal Union?) that: downgrade of the EFSF would also be particularly damaging and could affect significantly the ability of this institution to access the market. Should the EFSF struggle to access markets, a negative feedback loop would likely be created with the countries in most need of financial resources likely to suffer most as market participants would start questioning whether their funding needs could continue being met by the EFSF. Without any changes to the structure of EFSF, the existing bonds will be downgraded in line with France and Austria to AA+. This is because under the S&P treatment of EFSF, all bonds must be fully covered by triple-A guarantees, or by triple-A collateral. This will no longer be the case following the downgrade- see the impact for each of the outstanding bonds below.

EFSF Bond-by-Bond Backing

Bond Issued Amount Issued ( mln) Paid Out ( mln) Recipient AAA Guarantors Left France Austria AAA Collateral Shortfall* (%) Shortfall* ( bn)
(*not including any shortfall from AAA collateral)

2.75% Jul-2016 February 2011 5,000 3,600 Ireland 43.8% 25.6% 3.5% 28.0% 29.1% 1,454

3.375% Jul-2021 June 2011 5,000 3,700 Portugal 45.0% 26.3% 3.6% 26.0% 29.9% 1,493

2.75% Dec-2016 June 2011 3,000 2,200 Portugal 45.0% 26.3% 3.6% 26.7% 29.9% 896

3.5% Feb-2022 1.625% Feb-2015 November 2011 3,000 3,000 Ireland 61.7% 36.0% 4.9% 0.0% 41.0% 1,229 January 2012 3,000 3,000 Ireland/Portugal 61.7% 36.0% 4.9% 0.0% 41.0% 1,229

Total

19,000 15,500

6,299
Source: RBS

In essence this leaves the EFSF and the Euroarea member countries with two options: (a) Provide loan specific buffer to support the existing AAA bonds but accept a lower lending capacity going forward (b) Accept a downgrade to AA+, keeping maximum lending capacity at 440bn

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Try and Defend the AAA For existing bonds, the EFSF would need to pay in (or raise bond an additional 6.01bn1 to provide collateral to cover the loss of the AAA guarantees previously provided by France and Austria. There would also need to be a reallocation of any amounts from the loan specific buffers from the first three bonds (worth a total of 3.5bn) invested in AAA assets, which were French or Austrian AAAs. This includes the two sovereigns but also French and Austrian agencies, such as ASFINAG, CADES, CDC, OKB, OeBB, RFF and SFEF. Going forward, the EFSFs lending capacity would fall from 440bn to 271bn (a 169bn fall). For future bonds, the EFSF would once again need a loan specific buffer (i.e. AAA collateral) when raising debt, which would again mean not all of debt raised could be lent out (as for the first three bonds raised in 2011, see table above). The new bonds would be 61.7% backed by the existing AAA nations (taking into account their 165% over-guarantees) and the remaining 38.3% would need to be retained as AAA collateral. So for a new EFSF 5bn bond only 3,083bn could be paid out. Accept a AA+ rating The other option is that the EFSF accepts the lower rating of AA+ from S&P, meaning its lending capacity will not be impacted. This would have the additional benefits of EFSF keeping maintaining a remaining lending capacity of 396bn which can be used for (a) the second Greek bailout package (b) support through any of the other flexible EFSF tools (primary/secondary buying, flexible credit lines, bank recap) and (c) of course for the leveraging of the EFSF- though we remain particularly sceptical on this final point given these rating actions. Losing the AAA could have a number of other drawbacks: Firstly the spread to bunds (and to the EU/EFSM) is likely to widen. Given the rating differential this will further consolidate investors preference for bunds, especially nonEuropean investors and particularly considering the stable outlook on Germany. We have already seen a declining participation share from Asian investors over the five EFSF bonds and an increasing reliance on Eurozone and bank take up. Secondly, the perception that the bailout funds are the ultimate backstops for the system (which just need to be beefed up) will diminish even further. The rating actions show the positive feedback between deterioration in the periphery and worsening creditworthiness of the sovereigns behind the backstop facilities (i.e. the high correlation risk). General Implications for Bail-out facilities This further highlights the problem in depending on bail-out facilities, which are not prefunded, but instead rely on tapping wholesale markets at the moment when sovereigns are under severe stress. If the market instead knows there is already a stock of available resources, this reduces the likelihood of spreads widening significantly as investors realise the pressure on the bail-out fund to access the markets is lesser (much like the benefits of term funding for banks). This further highlights the need for a war chest to fight the crisis: in this case beefing-up IMF resources or accelerating paid-in capital for the ESM. As such we expect the focus to shift to the better-deigned, but not flawless, ESM structure and less focus being placed on the EFSF and particularly the attempt at leveraging. Euro area leaders have pledged to explore options for maintaining the EFSFs rating. However, ultimately we consider it highly unlikely they will be willing to
1 This assumes the guarantors states pay in the minimum to maintain the rating, taking into account the small buffer of collateral in additional guarantees and collateral available (289mln)

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inject funds directly or raise additional bonds solely to defend AAA ratings of the existing EFSF bonds, particularly given the associated fall in lending capacity for the facility going forward.

3. Implications for the ESM

The ESM is due to be launched as soon as member states representing 95% of the capital commitments have ratified it, which is expected in July 2012. The ESM will have a subscribed capital of EUR 700bn. According to the ESM treaty, the Eurozone countries will pay-in EUR80bn in five annual instalments of 20% each. The first instalment shall be paid by each ESM Member within fifteen days of the date of entry into force of this Treaty which is envisaged for July 2012. Moreover, during the five-year instalments period, ESM members shall provide, in a timely manner prior to the issuance date, appropriate instruments in order to maintain a minimum 15 % ratio between paid-in capital and the outstanding amount of ESM issuances. ESM Members will be irrevocably and unconditionally committed to pay on demand any capital call made on them within seven days of receipt. Before the downgrade of France and Austria, the ESM would have had a 58.1% share of AAA shareholders. If the six AAA euro area countries had been downgraded, then this share would have dropped to zero and it would have been highly unlikely for the ESM to achieve an AAA. Following the downgrade of France and Austria (and the confirmation of the ratings of Germany, the Netherlands, Finland and Luxembourg) the share of AAA holders has dropped to only 34.9%. However, given the high correlation of the expected assets (i.e. sovereign debt of bailed-out Eurozone countries), there is a significant risk that the ESM will not be able to be rated above the level of France, particularly if the lending volume significantly exceeds the paid-in capital. Assuming no credit is given by S&P for ESMs assets, if the ESM wants to achieve a AAA rating, then its lending volume would be limited to EUR 296bn (down from Eur500bn currently), comprising of EUR 80bn of paid-in capital plus EUR 216bn of AAA guarantees [(700-80)* 34.9%]. If the ESM wants to maintain its AAA rating and its lending capacity at Eur500bn, then subscribed capital would need to be increased to Eur1.280tr (from Eur700bn currently). This would lead to doubling in callable capital for all member countries. Should EU heads of States decide to double the lending capacity of the ESM (they agreed at the last Summit to reconsider the size of the ESM in March), then this would lead to an increase of callable capital to Eur2.6tr (or 27% of euro area GDP). Over recent months, there have been discussions about a potential increase of the capital from EUR 80bn to EUR 100bn and the acceleration of the instalment payments. Both measures would improve the credit standing of the ESM. Under S&Ps methodology, the advantage of paid-in capital over callable capital is that it would be added to 100% to the narrow risk-bearing capacity of the ESM whilst in the case of the callable capital only the AAA shareholders, which account for 34.9% of the total, would be added to the broad risk-bearing capacity. Again, assuming that no credit is given by S&P for ESMs assets, if the ESM wants to maintain its AAA rating, the lending volume would be limited to EUR 309bn- 100bn of paid-in capital plus EUR 209bn of AAA guarantees [(700-100)* 34.9%] in this case. Previous statements from German Finance Minister Wolfgang Schaeuble indicated the willingness of the German government to accelerate the capital provision, but not on a unilateral basis. We believe that several Eurozone member states (Portugal, Ireland, Greece but also Spain and Italy) would struggle raising the higher volumes in the current market environment, or at an accelerated pace. If the ESM drops the AAA target, the inclusion of French and Austria support would allow a significantly higher lending volume of EUR 440bn (in case of EUR 80bn of paidin capital) and EUR 448.5bn (in case of EUR 100bn of paid-in capital), respectively.

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4. Impact on European supranationals EIB

Following the downgrade of France and Austria, the share of EIB shareholders rated AAA by S&P has fallen from 62% to 43%. This does, however, not automatically trigger a downgrade of EIB. We actually believe that S&P will confirm EIB's AAA (90% chance) but there is nevertheless a tail risk. A negative outlook for EIB might prove to be unavoidable. The downgrades of France and Austria leave Germany, the Netherlands, Finland, and Luxembourg as well as Denmark, Sweden and the UK as the only remaining triple-A countries backing EIB. Whilst the loss of two of its AAA shareholder will put pressure on EIBs AAA rating, there are a number of factors offsetting this negative impact. First, EIB is an eligible counterparty at the ECB and the only supranational with access to central bank liquidity, which is highly supportive for the rating. S&P has highlighted liquidity as one of the key factors in rating EIB. S&P will also take into account EIB's high asset quality (no direct sovereign exposure) and its preferred creditor status.

S&P's math
One of the most important ratios for S&P is the risk bearing capacity of a supranational institution in relation to its purpose-related exposure. At year-end 2010, EIB had adjusted shareholders' equity (own funds) of nearly 40bn. As a consequence, its ratio of adjusted shareholders' equity plus provisions for losses (narrow risk-bearing capacity; NRBC) to loans, equity investments, and off-balance sheet items (purposerelated exposure; PRE) was 10.9%. In addition, EIB had almost 137bn in callable capital from AAA rated member countries. Accordingly, its ratio of NRBC plus callable capital from its AAA rated member countries (broad risk-bearing capacity; BRBC) to PRE was above 48% at year-end 2010.

EU
The European Union is somewhat different from the other supranationals, in so far as its credit quality is derived from the claim it has against the European budget; rather than on a share of callable capital. Please see below the layers of support outlined by S&P itself in one of its recent reports: (1) The EU can use its own cash balances or draw on the assets in accounts it has with member states, through which member states make "own-resource" payments to the EU on a monthly basis. These funds can be appropriated for debt service, whether or not they have been committed elsewhere. (2) Member states are legally obliged to balance the EU budget. The annual level of EU payments to member states has been set at 1.07% of EU-27 gross national income (GNI) over the period 20072013. Member states are committed (under COM[2010]160) to release funds to cover these budgeted expenditures. (3) Over and above member states' payments to cover budgeted payment appropriations, EU sovereigns are legally obligated to make payments up to the ownresources ceiling, which is expected to average 1.23% of EU-27 GNI over 20072013. We understand the difference between the own-resources ceiling (1.23% of GNI) and those budgetary expenditures covered by annual own-resource payments (1.07% of GNI) to be fiscal headroom available for debt service in case of default under loans granted or guaranteed by the EU. We expect this fiscal headroom to average around 30 billion in 20112012. (4) The EU is also empowered by European Council regulation to call on member states for funds in excess of the own-resources ceiling as the EU's legal obligations are ultimately supported by the member states.

Implications of S&P downgrades| 11 December 2011 Page 9

(5) In the event that one or more member states do not meet their legal obligations, the difference would be divided among the remaining member states in proportion to the estimated budget revenue from each of them. In December, S&P said that their review of the EU will focus on the financial ability of Eurozone member states to support the EU's debt service should the institution face a period of financial distress. S&P also highlighted that for 2011, budgeted revenues from Germany and France were 32% of total EU revenues, at 16% and 14%, respectively. In total, AAA rated member states accounted for almost half of the EU's 2011 budgeted revenues. The UK, Denmark, and Sweden together they contributed 13% of the EU's 2011 budgeted revenues. Given the EU's dependency on revenues from national budgets, S&P stated that it could lower the EU issuer rating by one notch if the AAA ratings on one or more member states would be lowered, with a special focus on the largest contributors, France and Germany. A downgrade of all six AAA Eurozone sovereigns would have most likely resulting in a rating cut of the EU. Following the downgrade of France and Austria, the support of the remaining AAA rated EU countries within and outside of the Eurozone will ensure that the AAA of the EU, in our view. However, we see a risk of a negative outlook. S&P said in December that if the ratings of all six EIB's AAA eurozone sovereign shareholders are lowered, the ratio of AAA rated callable capital as a percentage of the total callable capital (221bn) would fall from 62% to just under 22%. This would result in a fall in the BRBC to PRE ratio to 24%. Consequently, S&P placed EIB's placed the issuer rating on CreditWatch negative at the time (indicating a downgrade of EIB by one notch in such a scenario) However, given that only France and Austria were downgraded the BRCB to PRE ratio fell from 48% to 37% making a downgrade less likely, in our view. Moreover, supporting rating factors include the high quality of EIB's loan book, underpinned by conservative risk-management policies (as stated by S&P) S&P said that it will resolve EIB's CreditWatch placement within 90 days once they have completed the review of EIB's eurozone shareholders currently rated AAA. S&P also said that if they view the reduction in AAA callable capital as not being sufficiently offset by EIB's asset quality, they could lower the EIB rating by one notch, if any. We see a risk that EIBs rating outlook will be changed to negative reflecting the negative outlook for several of its AAA shareholders.

5. Political implications of the French downgrade 5.1 Implications for domestic politics
The French downgrade takes place at a politically charged time in France which is just about to enter in the general election campaign (first round: April 22nd, Second round May 6th). The rating downgrade has already been seized upon by the opposition to blame Sarkozys policies. Finance Minister Baroin on French Television tonight was quick to stress that the main reasons for the downgrade was due to the lack of effectiveness in the European policy response to the crisis rather than to French policies per se, something mentioned by S&P in its statement: the downgrade reflects our opinion of the impact of deepening political, financial, and monetary problems within the eurozone. Up until recently, Sarkozy had made it a priority to defend the French AAA. The downgrade will likely weigh significantly on the political debate in the run up of the French elections. His recent pro active stance on the crisis had resulted in an increase in popular support which led to a narrowing gap with Hollande from 5.5 points at the beginning of December to 3 points in the most recent polls. The downgrade could result

Implications of S&P downgrades| 11 December 2011 Page 10

in some erosion in Sarkozys position. It is also possible that the downgrade could benefit extreme right candidate Le Pen who has enjoyed a significant increase in popular support over the last few weeks (see chart). She has recently released her economic programme which includes among other things a return to the French Franc, the dismantlement of the European Union and the enactment of trade barriers. Despite these extreme views, most recent polls put her only 2.5 points below Sarkozy at 21.5%. A repeat of the 2002 elections when her father famously made it to the run off cannot be excluded (at the time her father got 17.8% of votes).
Le Pen enjoying a significant increase in popular support
35

30

25

20

15

10 12/9/2011 Hollande

12/15/2011 Sarkozy

12/21/2011 Le Pen

12/27/2011

1/2/2012

1/8/2012

Source: RBS

With a clear risk that Le Pen makes it to the second round, the spectre of such an outcome could have some impact on mainstream parties which might feel the need to adjust their rhetoric (towards a more nationalistic political agenda) to avoid losing more votes to the extremes. Overall, the downgrade will complicate somewhat the domestic political debate in France at such a sensitive time. It might also provide the opportunity for the extremes to seize upon populist themes such as euro exit as Le Pen seems to be determined in doing. While this is no doubt going to create some noise over the coming months, it is unlikely in our view, to change the outcome of the elections in a fundamental way with the next President to be either from the centre right or centre left party.

5.2 Implication at the negotiating table with European peers

We have been arguing for some time that a wholesale downgrade of all euro area AAAs would have probably created less frictions at the European negotiating table putting everyone in the same boat. The French downgrade in the absence of a German downgrade might strengthen the German position regarding negotiations around the fiscal compact and might prompt a last minute attempt from German officials to inject additional automaticity in the sanction mechanisms. Interestingly, the FT reported today that ECB Asmussen had sent a letter to the negotiators working on the Treaty where he expressed his concerns about the recent dilution of the Treaty: These revisions in my view clearly run against the spirit of the initial general agreement on an ambitious fiscal compact. While this is hardly surprising given the watering down of the Treaty under its latest draft, it will no doubt help Germany making its case heard. The difficulty of course is that any aggressive sanction mechanism would be interpreted in France as a potential loss of sovereignty which could benefit the extremes. This leaves very little room for manoeuvre for Sarkozy and does complicate in our view the future crisis resolution negotiations. Of note as well, S&P specifically

Implications of S&P downgrades| 11 December 2011 Page 11

mentioned in its outlook on France that it could face a further downgrade should it face a significant increase in contingent liabilities.

6. Market impact of ratings downgrades

The outcome of the ratings review is worse than a whole downgrade of the region. Be alert to a more muted market impact near term by domestic buying (France) and ECB buying (Italy) but the negative rating outlooks means risks can quickly return, especially over new concern for EFSF/ESM funding. The downgrade for France and Austria will mean some technical shifts into better rated markets for collateral purposes. The Austrian downgrade was not consensus but more generally the negative market outlook for France also hurts. Italy faces similar collateral demand weakening, and this continues a trend. The general EGB flow is buying in domestic markets and buying safety/liquidity. France will lose some traction on this score and since most of the debt in EMU is held by EMU residents (and can not be shifted out of Euros wholesale) then Bunds will see increased structural support towards that will keep short end yields negative and gradually support our bullish view on German bonds. We reiterate that the German bond view is not the same as a view on the German credit given the flow of funds. Italys move to a BBB+ means that it is now much closer to Junk status. Italian linkers are not yet out of the Barclays index. This is a real risk as austerity is likely to be selfdefeating and political risks remain. This is a problem for the markets as the firewall of the EFSF/ESM are hurt by ratings downgrades. Portugal is now Junk for all three major rating agencies. Ireland is now the same rating as Italy for S&P. Other impacts to watch include CSAs with French and Austrian agencies such as CADES and the LCH margin calculation.

What to expect near term

France: The ratings downgrade was largely expected in the case of France but it was not clear whether all EMU AAAs would be lost (with France 2-notches) or France would lose its AAA while Germany retained her status. In the event, it is the latter and for reasons we outline below, this is more negative medium term for France, but the near term impact can be muted. That is, rating action itself is not a huge surprise, and funds that are sensitive to such matters would be getting underweight French paper (a consensus anyway). The key reason we do not expect a huge moves in French rates/slope is however largely on the back of likely concerted action to support the debt market by domestics. Austria: The downgrade here will have come as more of a surprise to consensus but is not shocking in the context of CEEMA exposure via the banking system. The room to coordinate domestic buying is likely more limited (given the downgrade risk was seen as in line with Germany) and for this reason there may be more underperformance than France initially, though we see France as the weaker credit. Italy: The move to BBB+ moves Italy closer to Junk but there will be some funds unable to hold paper below A ratings levels now. This is likely to force selling pressure (index moves do not have to be done immediately) but the key point here is that even if LCH.Clearnet widen margins (see below) there is a backstop of support at some point in the short end from the ECB 3y LTRO and the ECB further on the curve. Italian linkers will continue to cheapen but the Barclays index for instance using the middle rating and it is only when another agency drops Italy in the BBB-handle that technical selling will

Implications of S&P downgrades| 11 December 2011 Page 12

be seen. So summarise, here: expect selling but there will be a mop up via domestics at the short end and the ECB more generally.

A narrower set of quality names for collateral and index and AAA curves
One of the reasons that a ratings downgrade in France/Austria is more damaging for these countries than wholesale loss of AAA in the Euro area is that the flight to quality still has somewhere to go. Not all investors are affected but there are a couple of areas where ratings are important, including for instance in collateral for tri-party repo. The tables below show the results from the last ICMA survey results and highlight that the bulk of the collateral pool is in AAA and unlike the U.S downgrade there are competing same currency assets that are deemed safe/safer. (Tri-party uses references ratings first before drilling into other detail.) In the case of Italy, with the drop to BBB+, the use of this paper in tri-party was we think diminishing after the ICMA survey but is still important.
Tri-party repo collateral by credit rating
Jun-11 AAA AA A BBB sub BBBA1/P1 A2/P2 NonPrime Unrated 49.8% 21.8% 13.1% 6.9% 2.2% 4.7% 0.0% 0.2% 1.5% Dec-10 46.6% 19.7% 20.1% 4.3% 5.1% 3.8% 0.0% 0.0% 0.4% Jun-10 51.4% 15.2% 20.9% 6.7% 2.2% 3.4% 0.0% 0.0% 0.1%
Germany Italy France Belgium Spain Other EMU UK DKK, SEK US Accession Japan Other Other Equity

Collateral from
Jun-11
22.4% 10.0% 9.9% 2.2% 7.1% 6.6% 11.1% 2.4% 2.4% 0.8% 4.2% 11.9% 8.0% 0.9%

Dec-10
24.3% 10.3% 9.4% 2.3% 5.2% 6.5% 11.6% 2.3% 3.1% 0.5% 2.5% 13.7% 7.6% 0.7%

Jun-10
21.3% 9.5% 8.6% 1.8% 4.0% 6.0% 9.9% 2.2% 3.1% 0.3% 2.0% 22.8% 7.4% 1.0%
Source: RBS

Source: ICMA, RBS

For index investors the trend is towards reducing exposure by changing mandates and often this is led by the end-user client who wants a rates product rather than a credit product. This is most significant for Italy which is closer now to junk and nonresidents will attempt to shy away from the market as far as possible because the sheer size of the market means that there is not exit door big enough for investors en masse. That said, the current ratings thresholds do not have very material index investor move risk but there will be some funds that invest only in single A-ratings and above, and in the context of the low market liquidity this is likely to see selling pressure in BTPs. Otherwise, the amount of AAA only index trackers is limited enough to suggest that the fallout should not be very marked from this source, a point that was also evident in the short lived reaction for Spain. In this case, the move was also widely anticipated and saw 10y SPGB/Bund spread only 3bp wider from the close of 19th Jan-09, when S&P was the first to downgrade, to 23rd Jan-09. This is why there is greater risk to Austria where the downgrade was rather less consensus, and allowed less scope for pre-positioning. There are also other investors that track EGB AAAs, for instance, Dutch insurance which references the ECB AAA curve to discount liabilities. We always thought that German, Netherlands and Finland were the more secure AAAs and so have been well prepared for French & Austrian downgrades. Prior analysis, from Neal Hegeman at

Implications of S&P downgrades| 11 December 2011 Page 13

RBS Insurance Solutions gave the results in the charts below. The results suggest some extra long end weakness from these investors.
The ECB AAA our calculation on the curve effects
3.5% 3.0% 2.5% Par Yield 2.0% 1.5% 1.0% post Austria + France downgrade (lhs) 0.5% Years 0.0%
1 2 3 4 5 6 7 8 9 101112131415161718192021222324252627282930
Source: RBS

The curve delta is large for hedgers using this curve

4% 3% 2% 1% 0%

0.70% 0.50% 0.30% Delta 0.10% -0.10% -0.30% -0.50% -0.70% 1 5 9 13 delta (rhs) 17 21 25 29

Par Yield

current ECB AAA curve (lhs) swap curve

-1% -2% -3% -4%

current ECB AAA curve (lhs) post Austria + France downgrade (lhs)
Source: RBS

The great debt shuffle: more home bias and more bias to safety/ liquidity (Germany)
The table below shows holders of government debt at end 2010. The key development is that debt ownership is unwinding a decade of integration with a bias towards more domestic sovereign support. Given that roughly 80% of denominated debt is bought by EMU residents then this debt shuffle is largely intra-EMU. Nevertheless, private sector ex-EMU residents will likely be less willing, at the margins, to hold riskier debt, while we expect large official sector holders to maintain exposures as they have done through the crisis.
Holders of general government debt, 2010 (% of total government debt)
Total residents Central Banks 1.4 0.2 3.2 3.4 3.6 0.3 0.4 0.8 1.7 Resident Other MFIs 23.5 31.5 23.9 28.4 27.0 47.5 18.2 12.0 22.4 12.5 26.5 Other Fin. Corp 14.7 9.2 0.3 7.9 15.6 10.6 6.9 5.8 1.2 11.9 Other residents 4.1 10.1 3.1 18.8 9.1 2.6 4.2 7.8 15.2 7.8 Non residents 56.3 49.0 69.6 41.5 66.2* 44.6 30.1 68.3 76.4 63.3 71.1 52.1 Source: ECSB, RBS

Belgium Germany Ireland Greece Spain France Italy Luxembourg Netherlands Austria Portugal Finland Euro area

43.7 51.0 30.4 58.5 55.4 69.9 31.7 23.6 36.7 28.9 47.9 * French data is from the Tresor

As such a crucial point is that while it is common to hear of non-EMU resident selling of EGBs, it is not clear that an exit from EMU debt markets is feasible for many holders. For instance, official sector holders such as central banks have wider goals than the private sector and many of the Swiss and UK holdings will be effectively offshore Euro

Implications of S&P downgrades| 11 December 2011 Page 14

centric funds that also cannot exit Euro exposure completely. Clearly that leaves room for large selling by other Non-EMU residents and this is expected to continue pressuring the Euro debt markets. The charts below attempt to tell a story that it is the intra-EMU debt that tends to be the dominant flow and therefore driver of the markets. That makes the analysis flow risk in the following order most important: 1 Debt shifts between EMU members (= increasing home bias) 2 Debt shifts to safer EMU debt by those investors (EMU and non-EMU) because some Euro area economic exposure is hard to avoid. 3 Debt shifts out of Euro area debt by all investors, most prominently by non-EMU investors.
Non resident debt holdings in tn (private & public) debt
14.0 12.0 10.0 8.0 6.0 4.0 2.0 2002 Official sectors UK, US, Japan, Swiss EMU to non-resident other EMU country debt

as a % of the total non-resident debt exposure.

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 EMU to non-resident other EMU country debt UK, US, Japan, Swiss

2003

2004

2005

2006

2007

2008

2009

2010

Source: IMF, RBS

Source: IMF, RBS

Where is the money going? The charts below show ownership trends in AAA sovereigns for European and nonEuropean banks, which highlights the demand for safety and liquidity and the ratings moves embellish the trend that has been in place already for several months.

European banks exposure non resident exposure to the public sector debts of .
300 250 200 150 100 50 0 Austria, Finland, France, Germany, Netherlands, Public sector Public sector Public sector Public sector Public sector
Source: BIS, RBS

Non European banks exposure non resident exposure to the public sector debts of .
140 120 100 80 60 40 20 0 Austria, Finland, France, Germany, Netherlands, Public sector Public sector Public sector Public sector Public sector
Source: BIS, RBS

Dec.2010

Mar.2011

Jun.2011

262 245 209

Dec.2010

Mar.2011

Jun.2011

127 122 118

130 94 106 35 36 41 15 20 23 42 46 46

55 55 61 15 16 20

4 6 6

3 5 5

Where is this buying of debt moving on the curve? The charts below show the results of the latest EBA stress test disclosures and show the stock of debt held in French and German sovereign paper. The chart on the right shows the distribution of the debt by

Implications of S&P downgrades| 11 December 2011 Page 15

bucket held across the EMU-11. There is a large proportionate holding at the short end (3m to 3y, at 48%) but there is also a large amount of duration held too.
German and French sovereign debt held by banks in the EBA stress tests
120 100
20%

Sovereign debt held by banks in the EBA stress tests, by bucket

25% EBA stress test data on EMU11 debt owndership by bucket 14% 10% 10% 5% 0% 11% 8% 15% 22% 19%

EUR bn

Germany

France

80 60 40 20 0 3M 1Y 2Y 3Y 5Y 10Y 15Y
Source: RBS

15%

3M

1Y

2Y

3Y

5Y

10Y

15Y
Source: RBS

All this helps to explain why German debt has continued to rally despite the clearer contingent liability for German as investors cannot ignore a region as large as the Euro area for commercial reasons such that some EMU debt exposure is necessary and going forward we expect a greater skew to the German debt markets and one which has been a key pivot in our ongoing bullish Bund market outlook. The ratings action mostly solidifies this tendency but there will be some new flows to further this bias and France and Austria become relative losers.

Other considerations
LCH margin trigger level versus the AAA reference spread
500 450 400 350 300 250 200 Sep-11 Nov-11 Jan-12
Source: RBS

The EFSF/ESM: Ratings threats make the already tough funding conditions for the much harder especially given the negative outlooks, and this will influence on the idea that the firewalls are less robust when most needed and this can impact as soon as the next weeks on likely Greek PSI failure. There may be areas where agencies of Sovereigns have CSAs that require extra collateral to be posted, perhaps such as French CADES.

Italian 10y over AAA benchmark 450bp threshold

The LCH.Clearnet margins for Italy were hiked today but this is not related to wide spread levels (a credit story) but is instead related to the volatility of the market. The bigger anticipation is a general increase in the margin requirement which can have a detrimental affect on BTPs (which in turn will be fought by the ECB). LCH.Clearnet could have already executed these margin hikes as the Italian spread has been above the 450bp general threshold in late December and earlier this month. The fact LCH.Clearnet has not moved highlights its flexibility to watch the markets to ensure such a move is permanent. On the basis of a AAA only reference rate (exFrance and Austria) for the margins, Italian 10y is again above the 450bp margin at 464bp but again there is no immediate implication. A factor to consider is that the narrower reference now to only Germany, Netherlands and Finland, may see a change in methodology where an average rating is used, or else continue to use the same names regardless as they are still considered core EMU.

Implications of S&P downgrades| 11 December 2011 Page 16

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