France's top AAA credit rating is likely to be downgraded and Germany could easily follow as the costs of bailing out weaker euro zone economies push up their own debt piles, says credit hedge fund firm Cairn Capital's chief investment strategist.
London-based Cairn, which has $24.5 billion in assets under management and advice across its business, said either future contributions to the European Financial Stability Facility (EFSF) rescue fund, or France's own economic troubles, could see it lose its coveted rating.
There are very deep economic flaws in the whole euro mechanism, said Graham Neilson, citing high debt levels, weak growth, divergence between member states and the European Central Bank's focus on inflation expectations.
France is likely to be downgraded either on its own metrics but more likely as a result of potentially higher EFSF costs. The bigger the EFSF, the more France is liable (and) the worse France's credit rating the more it could be liable.
Some commentators have suggested the EFSF, which will be able to give loans to countries, buy sovereign bonds and lend governments money to recapitalize banks, needs to be raised to as much as one trillion euros from 440 billion euros currently.
However, in a closely-watched meeting earlier this week, French president Nicolas Sarkozy and German chancellor Angela Merkel failed to come up with any increase to the EFSF.
France's own economics could also lead to a downgrade, said Neilson.
France's banks are three times more exposed to Italy than any other banking system in Europe and France's debt metrics and growth profiles are poor.
He added that Germany was also vulnerable to a downgrade, which would likely increase its cost of borrowing and put further stress on the global economy after S&P's downgrade of the United States earlier this month.
Germany could also quite easily be downgraded if the EFSF is forced to be larger, in a scenario where France and Germany end up with debt to GDP ratios of 120-125 percent. That's not good, that's not AAA, he said, adding that was likely to be the reason the EFSF had so far not been increased in size.
Neilson said that French and German credit default swaps (CDS), which have been traded by hedge funds in recent months and which have both roughly doubled since the start of July, had reached a plateau for now, and that there was a better opportunity in being long Spain by selling CDS.
We have preferred more recently to be long Spain than Italy spreads through the CDS, by selling protection. Spain is a lot better known as a risk and people's positions are more short.
He added that August's sharp market sell-off, which has already seen the FTSE 100 fall around 15 percent this month, is throwing up other opportunities for bargain-hunters.
There are some of the best opportunities of the past two-to-three years around, said Neilson. Certain assets have overshot to the downside and over the past week you've seen the real whiff of fear in the market.
Neilson said his funds have profited from one-year default protection on European banks, whose spreads have doubled or tripled since early July, and said he has spotted other opportunities in the financials sector.
We like good quality banks and insurers, particularly lower down the capital structure. Some bank capital instruments with early callability features have recently been sold down along with the market and as the early callability factor has been questioned, he said.
These types of securities allow the issuer to redeem at a point before maturity.
In German banks we've been on the long and the short side. There are some that you'd consider to be at the riskier end of the scale but the risks are better priced.
(Reporting by Laurence Fletcher, editing by Sinead Cruise and David Cowell)