OREANDA-NEWS. December 16, 2015. 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 been affirmed at 'AAA' and 'F1+'. 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:

Support from the 19 EAMS is strong. It takes the form of unpaid subscribed capital amounting to EUR624.3bn that can be called in case of financial difficulties. As of end-November 2015, the share of callable capital subscribed by 'AAA' rated EAMS was 34.8%. Including 'AA+' rated EAMS, the ratio is 37.4%, which largely covers ESM's projected net debt, defined as gross debt minus treasury assets rated 'AA-' and above, even in conservative scenarios.

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 (MDBs). The propensity to support is further enhanced by the importance of the ESM in the resolution of the eurozone sovereign debt crisis.

Given its role of providing emergency loans to EAMS in difficulty, the ESM may have to rapidly disburse large amounts of funding (up to EUR500bn) to countries at risk. Although it benefits from a preferred-creditor status only junior to IMF, the ESM has no concentration limit. Additionally, it is allowed to purchase equity participations up to EUR60bn. However, according to ESM's internal guidelines, should this happen, the maximum amount of sovereign loans would be significantly reduced (by a factor greater than 1 to 1).

In August 2015, the ESM approved a lending programme to the Greek government for a maximum amount of EUR86bn, out of which EUR25bn is earmarked for bank recapitalisation and resolution. However, the total financial support provided by the ESM is likely to be lower, depending on the IMF's participation, the actual funding needs as well as the timing of Greece accessing capital markets again. EUR20.4 bn was disbursed in 2015. Of this amount, EUR5.4bn was for the purposes of funding bank recapitalisation and resolution; the remainder will be disbursed until mid-2018, subject to the Greek government meeting conditions attached to regular reviews by the EU authorities.

The total loan portfolio amounted to EUR57bn as of end-November 2015. It also includes sovereign loans to Spain (BBB+) and to Cyprus (B+). The equity to adjusted assets ratio was 60% as of end-June 2015, and is projected to reach 37% by end-2016, assuming full disbursement of the Greek facility. If ESM reached its financing capacity limit, this ratio would be 14%-20% under Fitch's assumptions, depending on the amount of loans and equity participations. ESM policies require that paid-in capital and reserves always to be equal to at least 15% of outstanding debt.

Risk-management guidelines are conservative, especially for liquidity. Funds from paid-in capital cannot be lent and an amount equivalent of 15% of the maximum lending volume must be invested in assets of high creditworthiness and liquidity. ESM's available funds and the liquidity buffer must cover the ESM's liquidity needs for the next 12 months. Investment of liquid assets is governed by conservative rules. At end-April 2015, all treasury assets were invested in securities rated 'AA-' and above, and in central banks of the eurozone.

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

The ratings assigned to EFSF's debt rely on irrevocable and unconditional guarantees and over-guarantees provided by EAMS pro rata for 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. They ensure EFSF debt is fully covered by guarantees from the most highly rated EAMS or by the reserve. In the original FA (EFSF 1), guarantees on the original debt issues could be extended to 120% of their initial amount if a guarantor defaults on its obligations. The FA and deed of guarantees were amended in June 2011 (EFSF 2), to allow EFSF to extend the overguarantee percentage up to 165%.

Following the downgrade of France to 'AA' in December 2014, the rating of guarantees and over-guarantees (160.4% of initial amount) ensuring, with the cash reserve, full coverage of EFSF's long-term debt declined to 'AA' from 'AA+'. Short-term debt is fully covered by guarantees and over-guarantees (151.4%) rated 'F1+'. EFSF's outstanding debt totalled EUR184.6bn at end-September 2015, raised mostly to fund loans to Greece under EFSF 2. Debt under EFSF 1 amounts to EUR13bn and was issued to fund sovereign loans to Portugal and Ireland. EFSF stopped approving loans at end-June 2013 and will continue operating as an administrative body until all outstanding bonds and all loans are repaid.

Total EFSF loans were EUR174.6bn at end-November 2015, of which EUR130.9bn was extended to Greece. EFSF's large exposure to Greece is mitigated by the long maturity of the loans. No repayment of principal is due before 2023. If Greece defaulted on its obligations to EFSF, the deed of guarantee and the liquidity policy ensure that there would be sufficient cash reserves to cover the repayment of EFSF debt. The profile of its Greek debt means EFSF's current cash reserves are sufficient to absorb a default, and no guarantee call would be needed in the short term.

Debt and treasury assets are managed on EFSF's behalf by the ESM. Under EFSF 2, loan maturities are not fully matched to liabilities, while EFSF 1 applied back-to-back funding. The cash reserve, invested in high quality assets, has to be sufficient to service any debt payment at least three days before the payment date; 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.

RATING SENSITIVITIES
The Outlook on ESM's Long-term IDR is Stable. The factors that could, individually or collectively affect ESM's ratings are:
- A breach in internal guidelines (Forward Commitment Capacity; FCC) such that the total of loans and equity participations result in ESM's net debt (gross debt minus treasury assets rated AA- and above) not being fully covered by callable capital from EAMs 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 EFSF'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 ESM's overall mandate and operations.

The full list of rating actions is as follows:

ESM:
Long-term IDR: affirmed at 'AAA', Outlook Stable
Short-term IDR: affirmed at 'F1+'
Senior unsecured notes: affirmed at 'AAA'

EFSF
Long-term IDR of debt issues: affirmed at 'AA'
Short-term IDR of debt issues: affirmed at 'F1+'