* Belgium, France main guarantors for 55 bln euros of Dexia
* Negative carry, asset deterioration risks for guarantors'
* Dexia has 35 bln euro Italy exposure, 18 bln euros for
* Vast scale and short-term funding reliance were Dexia's
By Philip Blenkinsop
BRUSSELS, June 21 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
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
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
nationalise 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
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
"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 collateralised
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.