The threat of a credit downgrade to the euro zone's top economies leaves the bloc's EFSF bailout fund dangerously exposed, piling yet more pressure on the European Central Bank to step in as lender of last resort.
The fund has struggled to attract investors even with the backing of six AAA-rated governments, and on Tuesday S&P followed up a warning of possible downgrades for 15 euro economies by saying it is also reviewing the EFSF.
Expanding the lending reach of the European Financial Stability Facility (EFSF), agreed at an emergency summit in October, is central to the euro zone's plan to show investors it can stand behind its wayward sovereigns.
But much of the fund's ordinal appeal lay in the top creditworthiness of its guarantors, notable the euro's main paymaster Germany and France, the EFSF's second largest contributor.
Even so, appetite for the rescue funds own bonds had waned by its fourth auction last month, while its complex plans to attract nations with big foreign reserves, such as China, to invest in leveraging the fund's lending capacity met a cool response.
Standard & Poor's warning on Monday that it could cut the credit ratings of 15 countries in the bloc, including France and Germany, by 1 to 2 notches, makes the goal of leveraging the EFSF's funds to up to 1 trillion euros (859.97 billion pounds) look even more doubtful.
This can't be positive, said Guillaume Menuet, an economist at Citigroup. Any prospective downgrade to something that was supposed to be the best thing available is going to diminish investor appetite in the facility, especially if you had doubts about it in the first place, he said.
The AAA rating of the EFSF, which is backed by guarantee commitments for 780 billion euros and has a lending capacity of 440 billion euros, would be at risk if one of its guarantors were downgraded because the remaining AAA members would have to take on a bigger burden, in turn endangering their own ratings.
As for the EFSF, We could lower the long-term credit rating on EFSF by one or two notches if we were to lower the 'AAA' sovereign ratings, S&P said on Tuesday.
There's a sense that events are overtaking the EFSF and the leveraging may not work in time, said an EU diplomat with knowledge of discussions about the plan.
The EFSF declined to comment on Tuesday.
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ECB TO THE RESCUE
Following a meeting of euro zone finance ministers in Brussels last week, the EFSF said the leveraged fund should be fully operational from January. But concerns of a euro zone default could also make plans to offer first-loss bond insurance -- the other pillar of the EFSF's leveraging plan -- too costly.
Providing insurance on more than the first 20 percent of euro zone bonds in the case of default would eat up the 250 billion euros the EFSF has left, after lending to Ireland and Portugal, and aims to multiply.
Even before the S&P announcement, senior euro zone policymakers had expected the EFSF may only reach 500 to 750 billion euros in its new, leveraged form.
That sum is dwarfed by Italy and Spain's funding needs for the next three years of some 1.1 billion euros, should they find themselves unable to tap the markets.
The fund paid its highest yields on November 7 when it raised money for its Irish funding programme, and the fund's head, Klaus Regling, said the lack of details about how a leveraged EFSF will actually work were partly to blame.
The basic issue here is that the EFSF, even in unleveraged form, is starting to find it difficult to raise money of late, said Malcolm Barr, an economist at JP Morgan. So the idea that the EFSF is the vehicle to deal with this crisis is losing value, he added, speaking before the S&P statement was released.
Plans to increase the EFSF's firepower were introduced after the European Central Bank refused to consider giving a banking licence to the fund so it could draw upon ECB financing.
But the ECB remains the only European institution with the ability to play the role of lender of last resort.
The ECB is the only institution that can help now, said one European banker who advises clients on investing in euro zone debt.
Mario Draghi, the ECB's new head, signalled last week the bank may be willing to pursue more aggressive action if euro zone governments adopted what he called a fiscal compact.
European leaders will hold a summit in Brussels on Friday to try to calm panicky markets. France and Germany hope the ECB will be reassured by a master plan involving EU treaty change to impose budget discipline across the euro zone - and finally concede the sort of intensive bond buying that could restore confidence to the markets.
The door is open for the ECB to start leaning more heavily against the wind in the sovereign debt market, said Erik Nielsen, global chief economist at UniCredit in London.
(Editing by Ruth Pitchford)