OREANDA-NEWS. Fitch Ratings has affirmed the European Stability Mechanism's (ESM) Long-term Issuer Default Rating (IDR) at 'AAA' with a Stable Outlook and Short-term IDR at 'F1+'. The issue ratings of ESM's unsecured bonds have also been affirmed at 'AAA'. Fitch has also affirmed the Long-Term rating of the guaranteed long-term debt issued by the European Financial Stability Facility (EFSF) at 'AA'. The Short-term rating of the short-term (less than 12 months contractual maturity) guaranteed debt instruments issued by the EFSF has been affirmed at 'F1+'.

The affirmation of ESM's ratings reflects the strong support from Euro Area Member States (EAMS). The affirmation of the ratings of EFSF's debt issues is underpinned by guarantees and over-guarantees from EAMS rated 'AA' and above.

KEY RATING DRIVERS
ESM's ratings and Stable Outlook reflect the following key rating drivers:

The ESM has strong support from its 19 EAMS. Callable capital has increased to EUR624.3bn as a result of Lithuania (A-/Stable) joining the ESM in February 2015. However, shareholders' capacity to support has been weakened by the downgrade to 'AA+' from 'AAA' of one its shareholders, Austria (2.8% of capital), in February 2015, bringing callable capital from 'AAA' EAMS to EUR233.7bn. ESM's ratings were not affected, as in Fitch's view, shareholders' propensity to support remains above peers. This is underpinned by the emergency procedure, which allows ESM's managing director to call capital without approval of the governing bodies. This procedure is unique among multilateral development banks. Propensity to support is further enhanced by the importance of the ESM in the resolution of the eurozone sovereign debt crisis.

Although it benefits from preferred-creditor status only junior to IMF, the ESM could be exposed to significant risk exposure, given its role of providing emergency loans to EAMS in difficulty. In addition, the ESM has no concentration limit. At end-2014, financing was provided to just two sovereign borrowers, Spain (BBB+) and Cyprus (B-). The potential use of direct recapitalisation instruments (DRI) aimed at financial institutions in the eurozone experiencing difficulties was adopted in November 2014, but remains unused. The ESM has adopted an internal guideline - the Forward Commitment Capacity (FCC) - that allows it to adjust downward its maximum lending capacity by a factor greater than 1:1 relative to the level of approved DRI equity participations, whose amount is capped at EUR60bn. This implies that in the event that the ESM makes full use of the DRI envelope, the maximum amount of sovereign loans that can be lent to EAMS would be significantly reduced from its original EUR500bn.

The ratings assigned to EFSF's guaranteed debt reflect the following key rating drivers:

All EFSF debt is backed by irrevocable and unconditional guarantees and over-guarantees provided by EAMS pro-rata to their share in the European Central Bank (ECB), and a cash reserve. They are governed by an intergovernmental agreement (the Framework Agreement; FA) and by a deed of guarantee, both amended in June 2011. The 'AA' rating reflects the fact that all outstanding bond issuances are currently covered by guarantees and applicable over-guarantees provided by EAMS rated 'AA' and above, as well as a cash reserve.

EFSF has approved sovereign loans to three EAMS for a total EUR188.3bn, of which EUR174.6bn was outstanding as of end-May 2015 from Ireland (EUR17.7bn), Portugal (EUR26.0bn) and Greece (EUR130.9bn). EFSF stopped approving lending programmes at the end of June 2013 and will continue operating until all outstanding loans and bonds are repaid.

Total outstanding debt was EUR196bn as of 22 April 2015. Loans to Portugal and Ireland are funded by debt issued by the EFSF under the original FA (EFSF 1). This debt is covered by guarantees from EAMS and by a cash reserve, part of which is loan specific. Over-guarantees can be extended to 120% of their initial amount if a guarantor defaults on its commitment.

The June 2011 amendment to the FA (EFSF 2) has allowed EFSF to extend the over-guarantee percentage to up to 165%1. This ensured greater coverage of debt by the highest-rated EAMS. Under EFSF 2, loan maturities are not fully linked to liabilities, while EFSF 1 applied a back-to-back funding principle.

Conservative liquidity policies have been put in place to avoid cash shortfalls. At least three days before the due payment date, the cash reserve has to be sufficient to service any debt payment, incorporating, if necessary, transfers from guarantors. 10 days before the servicing of debt, it has to be at least equal to the share of the payment not covered by the highest-rated guarantors. The cash reserve has to be conservatively managed and invested in high-quality assets. Debt and treasury assets are managed on EFSF's behalf by the ESM.

EFSF's large exposure to Greece is mitigated by the long maturity of the loans. The average maturity for Greek loans is 32.5 years, and no repayment is due before 2023 (2018 for EFSF notes disbursed to Greek banks). If Greece were to default on its obligations to EFSF, the deed of guarantee and liquidity policy would ensure that there were sufficient cash reserves to cover the repayment of EFSF debt. Given that EFSF current cash reserves are sufficient to absorb a default, no guarantee call would be needed in the short term.

RATING SENSITIVITIES
The Outlook on European Stability Mechanism's (ESM) Issuer Default Rating (IDR) is Stable. The factors that could, individually or collectively affect ESM's ratings are:
- A breach in internal guidelines (Forward Commitment Capacity) such that the total of loans and equity participations resulting in ESM's net debt (gross debt minus treasury assets rated AA- and above) not being fully covered by callable capital from Euro Area Member States rated 'AAA' and 'AA+'.
- A downgrade of 'AAA' or 'AA+' rated EAMS that would reduce callable capital rated 'AAA' and 'AA+' to an amount lower than net debt.
- A weakening in treasury investment rules, leading to a reduction in liquid assets rated 'AA-' and above and, as a consequence, an increase in net debt that results in it not being fully covered by callable capital rated 'AAA' and 'AA+'.

The Long-term rating of European Financial Stability Facility's debt issues would be downgraded in the event of a downgrade of France's IDR to 'AA-' or below. It would be upgraded in the event of an upgrade of France.

KEY ASSUMPTIONS
The ratings and Outlook are sensitive to a number of assumptions:

- We assume ESM uses its maximum financing capacity as governed by the FCC.
- Fitch assumes that no large EAMS will choose to leave the eurozone and that highly rated member states will remain committed to responding to any capital call.
- Fitch expects no significant change in the overall mandate and operations of the ESM.
- Fitch assumes the eurozone will avoid long-lasting deflation, such as that experienced by Japan from the 1990s. Fitch also assumes the gradual progress in deepening fiscal and financial integration at the eurozone level will continue; key macroeconomic imbalances within the currency union will be slowly unwound; and eurozone governments will tighten fiscal policy over the medium term.