Europe: Downgrades Intensify Crisis

Despite the solid rebound in market confidence last week (well, up to Friday night in the U.S.), the European debt problems haven't gone away.

If anything, it has become more problematic, if that is possible.

French President Nicolas Sarkozy and the German Chancellor Angela Merkel met in Berlin overnight Sunday to try and reach agreement on a package of measures to help the eurozone's banks and end the continuing speculation on the issue once and for all.

The two leaders said they had reached agreement to strengthen the European banks, but wouldn't go into details.

"We are determined to do all that is necessary to guarantee bank recapitalization," Ms Merkel said at a joint news conference following the meeting.

"When it comes to recapitalizing the banks, our agreement with Germany is total," Mr Sarkozy said, but added the details had not been agreed on, which will puzzle markets.

Mr Sarkozy insisted that the two governments are ready to announce a comprehensive package before the G20 summit next month. The meeting came as reports surface of big investors bidding up the cost of insuring German government debt and widening spreads between French and German debt.

Big investors don't think these countries are in trouble; they just will have to give up some of their strong credit standing to help the weaker members of the eurozone and the area's banks.

The first dud bank is Dexia, the Belgian-French operation, and its rescue is all but a done deal following more talks and meetings over the weekend.

However, that deal hasn't come without cost, especially for Belgium with its ratings facing a downgrade.

According to reports, Belgium will buy the profitable retail banking business in its country for 4 billion euros.

The rest of the bank will be broken up and sold off with the local government lending business in France taken over by the French Government.

The meetings and moves at Dexia followed a spate of ratings downgrades on Friday.

Fitch cut the ratings on the sovereign debt of Spain and Italy. Standard & Poor's, Fitch and Moody's cut the ratings on a number of European banks and financial groups, including 12 UK financial groups, immediately raising the spectre of another bailout for the UK government-controlled Royal Bank of Scotland, which denied it needed any help.

That news in turn saw the euro dip, the stockmarket rally run out of puff in the U.S. and commodity markets pause.

In fact the euro lost all its gains from earlier in the week when the eurozone governments seemed to be coming to grips with the debt issue.

However, the big move on Friday was by Moody's, which put Belgium's credit rating on credit watch negative for a possible downgrade.

That could come in the next one to two months and would be very damaging to the continuing moves to stabilise the situation and build a convincing case for the markets that the eurozone would stand by all its banks and problematic states.

That's because a downgrade to Belgium's credit rating (Aa1 Moody's) will raise thoughts that Belgium (which does not have a government, has high debt and a big deficit) might need help, especially if Spain or Italy would need more help.

S&P has Belgium on a negative outlook for its rating of AA 2 and could cut that after Moody's announcement.

Downgrades of Belgium will add to pressures on the eurozone (and UK) banks, as will the downgrades to Spain and Italy by Fitch.

Helping the area's banks handle the coming avalanche of credit losses (and stress tests) is the major concern of the eurozone leadership.

Other guaranteeing countries would move to access the fund, leaving little or no money available to handle banks in Spain, Greece, Italy, Portugal and other countries which would also need help.

France and Belgium are already going to spend billions, either directly or through guarantees, in supporting and breaking up Dexia, and if Moody's is concerned about the impact on Belgium, it would be very concerned if France had to follow that with capital injections for some of its big banks such as BNP, Credit Agricole and Societie Generale.

Moody's statement on Belgium and Fitch's move on Italy and Spain has once again focused attention on the credit standing of all eurozone countries, even Germany.

Fitch downgraded Italy's sovereign credit rating by one notch to A+ from AA- and cut Spain's by two rungs to AA- from AA+, citing a worsening of the eurozone's debt crisis.

"A credible and comprehensive solution ... is politically and technically complex and will take time to put in place," it warned.

A string of European banks, including Britain's Royal Bank of Scotland and Lloyds TSB, also saw their credit ratings downgraded on Friday.

Overnight deposits at the European Central Bank (ECB) made by eurozone banks reached their highest this year for the fifth consecutive day as banks become less willing to lend to each other, a warning signal of a credit freeze.

The European Commission is expected to offer an outline of a plan to member states before the deadline of October 17, when European Union leaders meet for a Brussels summit.

In its statement on Belgium's rating, Moody's cited a number of potential problems: in particular Belgium could be vulnerable to increases in the cost of market borrowing for indebted European countries, weaker growth and the potential need to spend more bailing out failing banks.

Moody's added that Dexia is now facing ''significant'' challenges and there is increased likelihood for the need of additional government measures.

''It is unclear how far additional support measures would be likely to weigh on the balance sheet of the government.''

Moody's downgraded its ratings on nine Portuguese banks, citing the increased asset risk linked to their holdings of Portuguese government debt and the sovereign downgrade of Portugal in July.

Moody's also cut the ratings of two top British banks, citing a likelihood of less state support in a future crisis as Britain sought to reassure investors the sector was well capitalised.

Moody's cut its rating on Royal Bank of Scotland by two notches, downgraded Lloyds TSB by one notch, and cut its ratings on Santander UK, the UK arm of Spain's Santander, the Co-Operative Bank, Nationwide Building Society and seven other smaller British building societies.

It wasn't all downgrades. Moody's lifted the ratings on the basis of stand-alone financial strength for five institutions - building societies Co-op, Nationwide, Santander, Yorkshire and Principality.

Meanwhile, Standard and Poor's downgraded the core banks of Franco-Belgian financial group Dexia which was rescued back in 2008 in the first recapitalisation in the eurozone in the GFC.

Rival rater Fitch placed Dexia's bank entities on creditwatch negative.

More action will follow once the terms of the support and break-up packages for Dexia are known.