What went wrong with Dexia?

AppId is over the quota
AppId is over the quota
5 October 2011 Last updated at 23:09 GMT By Leo Kelion Business reporter, BBC News France and Belgium plan to break up Dexia because of its exposure to the eurozone debt crisis Dexia is set to become the first European bank to fall victim to the eurozone debt crisis.

A decision to split up its operations has been taken after investors sent its shares plunging to an all-time low.

As late as 27 September the firm's board boasted of a "robust capital base" and insisted a break-up was firmly off the agenda.

But one week on, Belgian and French finance ministers plan to split off the firm's riskiest assets into a "bad bank" and remove its French local government lending operations.

So how did Dexia get into this mess?

Origins

Dexia was created in 1996 when Credit Local de France merged with Credit Communal de Belgique.

The company combined France and Belgium's biggest municipal lenders providing finance for spending on schools, public transport, street lighting and other locally controlled budgets.

It also included a retail branch network in Belgium and a private banking unit in Luxembourg.

The aim was to strengthen the business ahead of the euro's launch in 1999. The single currency's introduction was expected to increase competition across the bloc's banking sector.

Over subsequent years, Dexia continued to expand. It took control of the Italian lender Crediop, Belgium's Artesia Banking Corporation, the Israeli bank Otzar Hashilton Hamekomi and Turkey's DenizBank. It also formed a joint venture with the Royal Bank of Canada combining their institutional investor services units.

The first bailout

Dexia's bigger-is-better strategy first came unstuck in 2008. The collapse of the US investment bank Lehman Brothers caused lenders worldwide to become wary of lending to each other.

Attention focussed on Dexia's loss-making US asset management and bond insurance unit, FSA. It had been caught out by the sub-prime mortgage crisis.

In June that year, Dexia had been forced to announce that it was providing a $5bn credit line to the subsidiary, but the sum was still dwarfed by the unit's distressed assets.

Finding itself unable to borrow placed Dexia in an impossible situation. It relied on being able to take out short-term loans to finance the longer term credit it offered public authorities.

On 30 September 2008 the governments of Belgium, France and Luxembourg announced they were taking control of the business with a 6.4bn euro bailout funded by the three governments and the firm's existing shareholders.

According to France's finance minister Christine Lagarde, there had been a risk that Dexia "would not make it through the day, which would have represented a systemic risk for the stability of the financial system".

The move in 2008 had been supposed to put the business on safe ground, yet three years later Dexia requires a second rescue.

Eurozone debt crisis

While problems in the US prompted the first intervention, the eurozone debt crisis is at the root of Dexia's current difficulties.

The firm has 3.4bn euros ($4.5bn, ￡2.9bn) of exposure to Greek government bonds. Analysts estimate it has a further 17.5bn euros of exposure to sovereign debt issued by Italy, Spain, Portugal and other troubled eurozone economies.

In spite of all this, Dexia passed July's banking stress tests carried out by the European Banking Authority.

This happened because the bank had a core tier one capital ratio of 10.3%.

The measure weighs up a bank's top-notch assets against its more risky holdings and is used to gauge its financial strength. Dexia's score put it well above the 6% threshold demanded for a clear pass.

So on 15 July, the bank issued a press release headlined "2011 EU-wide stress test results: no need for Dexia to raise additional capital".

The problem is that the tests did not take into account a scenario in which Greece might default on its bonds.

Dexia has written down the value some of its long-term Greek holdings by 21%. However, some speculate that creditors may ultimately have to absorb a 50-60% loss.

While the bank should have enough capital to absorb such writedowns, analysts are worried about the knock-on damage to other investments owned by the bank that would be caught up in the turmoil.

"Of course, the Greek exposure is a consideration," says Pierre Lambert, a banking analyst at Keefe Bruyette & Woods.

"But the key catalyst today is its freeze of access to market short-term liquidity.

"Dexia relies on short-term funds, which are renewed on a rolling basis. But the access to those funds is no longer there because of market concerns about its exposure to the euro periphery and the requirement of higher collateral."

Record loss

Dexia had made efforts to clear its balance sheet of risky assets.

Dexia's corporate motto is "Short term has no future"

In May, it announced plans to sell off low quality US mortgage-backed securities and other loans.

At the time, investors applauded the decision, but it came at a cost. Dexia had to mark down the value of the assets by 3.6bn euros.

That propelled the bank to a record loss in its second quarter. Furthermore, worries remain about what is left on its books.

"Back in 2008 the bank reclassified over 100bn euros of trading assets as loans, which had the effect of it not having to mark them to market value," says Simon Maughan, a banking commentator at MF Global.

"Its view was that if it held them to maturity they would be paid back, but the outcome has been very different. And these legacy assets have only been partly addressed."

In August, Dexia's chief executive said that it should return to profit in its third quarter, but the firm was already on some analysts' danger lists.

On Monday, the ratings agency Moody's warned it was considering cutting the firm's credit score, saying that the bank was finding it increasingly hard to source funds.

Dexia's shares closed more than 10% lower on the news before falling as much as a further 37% on Tuesday after details leaked of a crisis board meeting.

That evening, France and Belgium announced plans for a second rescue.

Why it matters

Guaranteeing Dexia's loans puts extra pressure on Belgium and France's finances, but the rescue has wider implications.

The stress tests' failure to highlight Dexia's vulnerability calls into question how many other European lenders are at risk.

Until the debt crisis is resolved, the issue of contagion remains.

As Andrew Bell, chief executive of Witan Investment Trust puts it: "You can put a firebreak around Greece, but as soon as the markets start worrying about the solvency of big countries like Spain and Italy and possibly even France eventually, at that point the amount of debt held by a wider range of banks is so much greater."

Dexia is also a reminder of the financial system's interconnected nature.

The bank plays a key role in helping some US states and cities raise funds. Concerns about its health have caused their borrowing costs to rise.

Breaking up Dexia may offset the dangers posed by its collapse, but it also serves as a warning that the debt crisis can cause unforeseen damage so long as it remains unresolved.

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