Moody's signals eurozone downgrades as stability mechanism inadequate

Moody’s Investors Service said it can’t rule out further credit downgrades for euro-region nations because the agreement on a permanent bailout fund, the European Stability Mechanism (ESM), doesn’t go far enough.

European Union leaders met on March 25 and set out new rules on bailout loans. Their failure so far to provide a permanent system whereby stronger nations support the finances of their weaker counterparts leaves bondholders at risk, Moody’s said.

“The absence of a fiscal-transfer mechanism and the conditions under which assistance will prospectively be made available leave downside risk to private creditors,” the rating agency said in an e-mailed report today. “Consequently, further rating downgrades cannot be ruled out.”

Bonds of Europe’s so-called peripheral nations have fallen since the summit in Brussels. Portuguese bonds’ extra yield, or spread, over their German counterparts soared to a euro-era record today on speculation a bailout is inevitable. Standard & Poor’s (S&P’s) cut its ratings for Portugal and Greece on March 29, while Fitch Ratings has said the ESM, which starts in 2013, won’t allay concern that nations may need to restructure debts.

Moody’s rates Greece B1, Ireland Baa1 and Portugal A3.

‘Debt overhang’
Funding costs for stressed nations are likely to remain problematic because of their “low projected economic growth and in some cases a significant debt overhang,” Moody’s said.

“The pact also confirms very distinctly the possibility of a debt restructuring if countries do not comply with the conditionality of the programme that they’re in,” Bart Oosterveld, managing director of sovereign risk at Moody’s and one of the report’s authors, said today in a telephone interview.

As private creditors’ claims would be subordinated to EU-level lending, “recoveries would probably be very poor for both current bondholders of stressed sovereign credit and future bondholders,” he said.