A severe stress scenario of a double dip recession and an interest rate shock would result in rating downgrades for several European sovereigns, according to a new scenario analysis by Standard & Poor’s. In such a scenario, current EU and IMF support mechanisms may be insufficient, S&P adds.

It likely would also prompt the recapitalization of numerous banks in Spain, Italy, and Portugal (banks in Ireland have already been dealt with). Furthermore, issuers and transactions closely related to governments and domestic economies would likely suffer materially and could see significant downgrades.

According to our calculations, the current funding mechanisms sponsored by the EU and the IMF would be able to support the borrowing requirements of Greece, Ireland, and Portugal, and a small sliver of the requirements for Italy and Spain under benign economic conditions. We believe this safety net, however, would be insufficient if conditions were to deteriorate along the lines indicated in our stress scenarios, prompting a higher level of support for Italy and Spain. Under such a situation, the additional cost for the remaining guarantor countries could cause them to look for alternative forms of support.

Although our scenarios take into account various debatable assumptions, we believe that they illustrate the likely general direction under given conditions. Beyond the likely downgrade of a number of sovereigns if such events came to pass, our scenarios suggest that current support mechanisms may not be sufficient if conditions deteriorate beyond current expectations.

For details see Stressing The System: Assessing The Capacity Of The EU And IMF To Support A Eurozone Under Strain

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