It is more tiring each day to consider how much Europe has the world by the throat.  Everyone in the U.S. is looking for a flash point, or a flushing sound, or something that signals the beginning of the end.  So far, nothing.  The potential catalyst, or the great flush, could be the blow-up (and possible rescue) of Dexia after the Belgian-French bank fell by more than 22% to about $1.01 Euro on Tuesday.  

Reports came out late in the day from the WSJ that Dexia was going to set up a “bad bank” to house its troubled assets with some additional government assurances.  This situation still has the potential of turning into the next Long-Term Capital Management blow-up, or it even be a miniature version of the next Bear Stearns or the next Lehman Brothers.  If things are hinged this deeply on news of Dexia setting up a Bad Bank, then a rally like we saw today could be one flash point that investors are looking for.  Imagine if things fall apart.

The big problem is that most non-European people do not know who or what Dexia is, nor do most people know what an implosion or restructuring would really create as far as cause and effect.  Dexia is a Belgian-French bank that is based in Brussels and it has offices located in Belgium, France, Luxembourg, and Turkey.  It was actually bailed out before, so the Bad Bank would be considered a second bailout.  What will seem so different is that this was not a European bank based in the lands of the PIIGS.

It still seems questionable as to whether or not the Europeans would bail it out after Belgium, France, and Luxembourg already bailed it out with capital assurances and with liability guarantees with counterparties.  The Europeans have so far been so slow to react to even worse developments that it would be a nearly amazing if they showed up on time here.  Dexia was also eligible at one point during the 2008 to 2009 financial crisis for U.S. bailout money due to having New York offices under the FSA name.

Dexia is believed to hold many government bonds from the lands of the PIIGS like Spain, Greece, Italy and elsewhere. It is said that these holdings would more than gobble up its entire Tier-1 capital that is used for banking reserve assets.  Our understanding is that Dexia has more short-term funding needs more than it does long-term financial stability.  In short, if Dexia has to access capital it will either be unavailable or will come at too high of a price.  The company’s recent financial data sowed that its Tier 1 ratio of 11.4% as of 30 June 2011.

At the end of September, Dexia noted after a directors’ meeting: ” Jean-Luc Dehaene stressed that contrary to certain rumours the Board of Directors and Dexia shareholders, both public and private, exclude any scenario involving a demerger of the Group. It is the responsibility of all the shareholders to manage the heritage of the past and work to guarantee its future.”

In mid-September, Dexia also noted, “A series of negative news about Dexia was published… The Group is once again at pains to stress the stable nature of its shareholding and solid capital base… Dexia has implemented the whole of its long-term funding programme for 2011, having raised EUR 18.4 billion of long-term resources as at (of) 9 September 2011.”  At that time, Dexia also noted that it has no intention of borrowing on the senior unsecured market.  That is now almost three weeks ago, and whether you believe a bad bank changes that statement is up to you.  Again, Dexia closed down over 22% and it was down by about one-third at the peak of selling.  Dexia was also up at 1.50 Euro just a week ago. 

Dexia was bailed out in 2008 and it, like many of the other banks, has been shrinking its balance sheet while still holding many underperforming or toxic assets.  It still had more than 500 billion Euros in assets (at June 30), down about 15% from a year earlier.  It is supposed to be a top-25 in bank asset size in Europe as well.  If one bank fails, what is the rationale that there are not other failures lurking.  If Dexia were to suddenly fail, what about its counterparties?  Will they suddenly get pinched?  Dexia easily passed that silly out of date E.U. bank stress test this summer.  What does that imply for the banks that were more at risk?  Whatever it implies, it cannot be good.

Another concern is that Dexia’s United Stated activity was often geared toward lending to U.S. municipalities.  Sadly, that could drive up a municipal entity’s borrowing costs even higher than they are today.  Could Dexia make Meredith Whitney’s projection of massive muni-defaults correct?  Maybe not, but it doesn’t help.

The news today is that the Bad Bank would carry assets of around 180 billion Euro and would come with assurances from Belgium and France.  Dexia was certainly not the only catalyst today for the early drop nor for the late-day snap-back rally.  The rest of Europe is on fire and the regulators and those who could save things are more interested in coming up with financial transaction taxes or saying how they don’t want to be on the hook.  So much for the term “Union.”  The European experiment might need to be renamed the “European Confederation.”

Being an American makes it hard to call Dexia the next Long-Term Capital or even the next Lehman Brothers or Bear Stearns.  Long-Term Capital was highly leveraged, as were Lehman and Bear Stearns.  How leveraged Dexia is in comparison seems to be less of the case, but it all depends upon what it can throw into the bad bank and how much the French and Belgians are willing to guarantee. 

It is easy to hope that this plays out the way the reaction came on the news of a Bad Bank.  We are unfortunately dealing with the European do-nothing or do-it-too-late regulators.  That means that a deal is not final even if a deal is announced.  The announcement “confirmations” merely need to be challenged with this question” How do we know that both sides will honor the deal?”   The bank has to get the funds in hand, and we all know now that both the Europeans and the Americans have no qualms about coming in with new conditions on a bank after-the-fact with new regulations or rules.  It is the new normal.  Look at Greece… Greece had a deal, yet that deal is in jeopardy after the fact.

The hedge fund Long-Term Capital imploded and it was a better financial trade for the trading partner banks to break the hedge fund than it was to rescue it.  To say that Lehman and Bear Stearns were bailed out would be perhaps the greatest exaggeration of the recession.  It would be like saying that Angelo Mozilo has a light tan.

We’ll know in the morning whether or not Dexia’s rescue is legitimate or whether it was aggressive reporting.  Either way, this feels like a scenario that could be somewhere in between a blow-up of the hedge fund LTC and either the brokerage and financial firms of Lehman or Bear Stearns.  That is, if a rescue does not gt finalized and is delivered upon. Pick your poison.

If European nations will support Dexia, perhaps they won’t allow the other banks to fail either.  After all, how can they tax institutions if those institutions implode into failure? 

JON C. OGG

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