BRUSSELS With tens of billions of euros lent to the public sector in Spain and Italy, bailed-out lender Dexia may be dead as an investment but as a threat to the budgets of guarantors Belgium and France, it is very much alive.
Dexia, the first bank to require a rescue during the euro zone crisis, risks becoming a prime example of contagion from the troubled countries on the region's southern periphery to the more stable ones at its northern core.
The Franco-Belgian group, which at its height was the world's largest municipal lender, with business across Europe and a large U.S. empire, was seen as too important to fall and was rescued for a second time in three years last October.
Already stripped of most of its businesses, it now faces a future as a holding of bonds and loans in run-off, with state guarantees to support its funding and prevent a Lehman-like collapse and domino effect.
But this is not the end. Officials say it will likely need yet another injection of taxpayers' money that would sink French and Belgian public finances further into the red.
Bernhard Ardaen, a former Dexia banker who has authored a book on Dexia's collapse called "Time Bomb", says Dexia's needs could eventually swell the French budget by 75 billion euros, while Belgium's public debt could shoot up by 150 billion euros to 1.5 times its annual output.
"Interest rates would explode, and the country would immediately head into a negative spiral. Then a Greek scenario for Belgium would no longer be unthinkable," he wrote.
Ardaen accepts this is the worst-case scenario. Yet even in the best case, further government intervention appears inevitable, with a possible 2 billion euro top-up per year - not enough to bankrupt a state, but sufficient to provide a budget headache.
Belgian central bank governor Luc Coene has said Dexia will very likely need fresh capital at some point in the future.
Belgium has already paid 4 billion euros ($5.1 billion) to nationalize Dexia's Belgian retail banking arm; France is looking to take on its French public lending operations, and the two states and Luxembourg are guaranteeing up to 55 billion euros of Dexia's funding.
Dexia wants the total to swell to 90 billion euros, close to the recently agreed 100 billion euro bailout for Spain's entire banking sector.
After making an 11 billion euro loss last year, Dexia's shareholder equity is drying up, meaning it has little or no room to absorb further losses, hence the need for new funds.
The states are already bound to Dexia through the guarantees to cover Dexia's funding, with Belgium providing 60.5 percent, France 36.5 and Luxembourg 3 percent.
In an ideal world, they would simply benefit from the guarantee fees Dexia is bound to pay. In reality, they may need to cover losses incurred from negative carry - the situation of funding costs exceeding asset income.
If the assets themselves fall in value, France and Belgium may find they are bound to pay substantially more as Dexia's debtors come to them to get their money back.
MAJOR MUNICIPAL PLAYER
Dexia might have remained a mid-sized Franco-Belgian public financier with a Belgian retail arm, but under the decade-long leadership of Frenchman Pierre Richard after its formation in 1996, it became the most important lender to local authorities.
The group expanded across Europe, becoming a big player in Italy and Spain, and opened offices from Mexico to Japan.
In 2000, it sealed its status as the number one in its field with the purchase of U.S. bond insurer Financial Security Assurance (FSA). Customers included the cities of Chicago and Houston, housing agencies from Alaska to Texas and the New Jersey Turnpike Authority.
Dexia provided credit enhancement to U.S. bond issuers, principally cities and public bodies, but also pushed into selling them guaranteed investment contract funds that guaranteed interest and reimbursement. However, it faced large losses in 2007-2008 with that money invested in securities such as subprime mortgage bonds.
Dexia also acted as buyer of last resort for municipal bonds by writing standby bond purchase agreements, under which it agreed to acquire any unsold portion of a debt issue. It received a fee for this service, which increased if the municipality failed to find buyers and fell back on Dexia.
A Dexia insider said executives believed they had found a failsafe moneyspinner and allowed exposure to this sort of insurance to rise to $55 billion by August 2008.
The company also became what one insider called an "asset accumulator", scooping up structured products that investment banks had created in order to achieve the 10 percent annual earnings growth and 15 percent return on equity it had promised to shareholders.
"We had assumed that it was a risk-free business. That assumption proved too optimistic," Ardaen told Reuters. "It worked well until the tide turned. Then they got stuck."
CREDIT CRUNCH VICTIM
U.S.-based Lehman Brothers and AIG were felled principally by exposure to subprime mortgages. And while Dexia had its share of poor assets, its main problem was a mismatch between the terms of its borrowing and its lending.
Its business of financing municipalities and other public authorities meant making long-term loans. To finance this, Dexia relied on short-term borrowing. In boom times, the group could profit from the difference between lower short-term and higher longer-term interest rates.
In the 2008 crisis, when banks stopped lending to each other and the short-term money dried up, the model collapsed.
"The problem is that what was never supposed to happen did happen," said an insider, who did not want to be identified.
The scale of its operations was also a problem.
Dexia had a balance sheet of more than 650 billion euros at the end of 2008. Loss-making U.S. subsidiary FSA, sold in 2009 to Assured Guaranty, was an additional $500 billion business. Lehman Brothers' balance sheet, at the time of its collapse, was around $700 billion.
Critics note that neither Richard, nor high-flying Belgian lawyer Axel Miller, who joined Dexia in 2002 and took over as CEO from 2006, were really bankers. Current Dexia Chairman Jean-Luc Dehaene has accused them of megalomania.
At a shareholders' meeting last month, the majority present pinned the blame for Dexia's downfall on Richard and Miller.
But Miller has said remedies he presented to the board before the initial 2008 rescue were ignored. Richard has said that Dexia was not alone in growing and that no one had foreseen the possibility of a total closure of credit markets.
"Our strategy was perhaps too ambitious, but it was always plain to see," Richard told a parliamentary commission in December. "No authority raised an objection, and the board always approved it."
In 2011, Dexia faced a similar problem. The credit crunch returned, this time because of the euro zone debt crisis.
Banks with a heavy exposure to the bonds of indebted countries were particularly punished in the credit markets, and in October, Dexia was rescued again, just three months after passing an EU-wide test of its resilience to stress.
With 5.4 billion euros of Greek government debt, the Brussels-based group had one of the highest exposures to the troubled country of any non-Greek firm.
It and its former Belgian unit took a collective 4.6 billion euro hit last year from writing down Greek holdings.
During the crisis at the end of 2008, after its first rescue, Dexia became the heaviest user of the U.S. Federal Reserve's "discount window" loans, draining almost a quarter of all the money available in the record final week of October.
It also soaked up 11 percent of the European Central Bank's refinancing at that time.
Since then, it has relied heavily on central bank funding.
Dexia is among the largest known takers of the ECB's two exceptional low-cost funding operations, LTROs, in December and February this year, soaking up 35 billion euros.
But this may not be enough. The euro zone crisis has entered a new phase, with the focus turning to Spain and Italy, where Dexia has a heavy presence from public lending there.
This includes exposure of 35 billion euros to Italy through its unit Crediop and 18 billion to Spain via unit Sabadell. This includes 12 billion euros of Spanish and Italian bonds, which have come under pressure in the markets.
The prospect of losses from borrowing costs exceeding asset yield - which analyst say could be 1 to 2 billion euros a year - and of the asset values being under pressure - which could cost tens of billion of euros - has prompted talk of a third rescue down the line.
Gutted of all its businesses, Dexia has no realistic hope of making any money. It cannot grant new loans and so misses any benefit from charging its public-sector customers more.
Under October's rescue deal, Dexia was made to sell profitable businesses and now has the task of steadily winding down its bond and loan portfolio.
It could follow the example of the Dutch-Belgian Fortis, which collapsed in the weeks after Lehman in 2008.
The Fortis portfolio of assets, including mortgage-backed securities, U.S. student loans and lower grade collateralized debt obligations, was grouped together in a special purpose vehicle given the elegant title Royal Park Investments (RPI).
Bought for 11.7 billion euros in May 2009, a hefty discount to its nominal value of 20.5 billion euros, it has made 648 million euros of profit in the past three years.
But Dexia cannot conveniently write down the value of its far larger holdings, because this would have to be borne by taxpayers in Belgium and France.
On the positive side, "junk" quality securities make up just 9 percent of those debt holdings, compared with 66 percent for the old Fortis assets in RPI.
For now, public authorities across Europe are continuing to pay Dexia its dues, and if Spain and Italy fare well, that low junk exposure could be kept in check. Belgium and France might be only liable to pay a few billion euros.
But if either country, or their regions, were to drift into junk status, Ardaen's time bomb would go off.
($1 = 0.7889 euros)
(Editing by Anna Willard)