Standard & Poor’s said yesterday (Thursday) that covered bonds from Italy, Portugal, Spain, Ireland and Germany could be downgraded under two possible stress scenarios, according to an updated analysis, as the euro-zone sovereign debt crisis continues to unsettle investors.

EC President Jose Manuel Barroso

The analysis came as hopes of a resolution to the crisis were undermined by renewed disagreements between France and Germany about the shape of any rescue package, which could put back any finalisation of a package.

“The financial markets are jittery,” said S&P. “Recovery in many developed economies is stubbornly weak, faltering even, and investors seem increasingly nervous about the ongoing sovereign debt crisis in Europe.”

S&P introduced two possible scenarios, projecting that under either a double-dip recession, or a double-dip recession accompanied by an interest rate shock the sovereign ratings of France, Spain, Italy, Ireland and Portugal would probably be lowered by one or two notches.

The rating agency projected that the impact would be “hardest on sovereigns and sectors most closely aligned with the credit fortunes of governments, such as government-related entities, local and regional governments, and banks”.

S&P estimated that the total recapitalisation costs for the Spain, Portugal, Italy and Greece would be between around Eu10bn and Eu50bn.

Covered bonds from Italy, Portugal, and Spain would be susceptible to a two to three notch downgrade in the event of a respective sovereign downgrade of one or two notches because the banks are expected to take a harder hit. For example, Spanish banks are expected to be downgraded by up to five notches, and Portuguese banks up to four notches.

Covered bond programmes in Ireland and Germany would be expected to be lowered by one notch. S&P noted that that 90% of other covered bond programmes (by issuance outstanding) could keep their ratings if the issuer were only lowered by one notch.

Barclays Capital German head of strategy Fritz Engelhard, said the hypothetical actions were not surprising.

“It’s clear that under the current methodology that if S&P lowers the sovereign rating, this will have a knock-on effect on banks, and then on the covered bonds,” he said. “The suggested downgrades of the banks in the respective stress scenarios will clearly lead to further rating pressure on covered bonds. That’s still within their methodology, this link between banks and covered bond ratings.

“What’s interesting, though, is that they did not seem to be concerned about the performance of collateral assets,” he added. “I would think they may also apply higher haircuts on cover pools, particularly in the scenario where they stimulate a double dip recession combined with an interest rate shock.”

S&P said that its base case projections are reflected in current ratings. It said that it would incorporate any new developments at an EU level once they are known.

S&P stress scenarios

Source: Standard & Poor’s