Monday, 10 October 2011

Dexia and Pripheral Crisis. Stop blaming the Periphery. Dexia is NOT Greece

Barely three months after Dexia passed with flying colours the now infamous EBA tests with 11% equity buffer compared to the 10% that was required, Dexia (Belgian part) is being nationalised. The year 2008 may seem such a long time ago, but France, Belgium and Luxembourg bailed Dexia out then with 6.4bln.

I have read with some amusement many articles attributing this latest Bank crisis to the portfolio of Greek bonds that European banks hold and to the inadequacy of the EBA tests to account for default in the periphery of Europe.

It is true that Dexia holds GGB’s in their portfolio but this is not the root of the problem. After all back in 2008 when Dexia was saved for the first time, there was not a whiff of Greece going bust. Dexia’s balance sheet in 2010 was 560bln- however the interesting thing is their Financial instruments portfolio and their Level II and Level III assets. For example, in 2010, they had assets of 83bln in Levels 1,2 and 3 and almost half of these were in Level III (unobservable inputs, basically marked to fiction). Similarly on their Liabilities have 63bln of derivatives booked as Level II (value derived from a model with observable inputs).

Structured Products Hedging

How did all these derivatives arise in Dexia’s balance sheet? Well, Dexia has many entities but maybe the interesting one is the Municipal Agency. For many years now, Dexia was in the market for structured swaps as a liability hedge to French and other European Municipalities for their loans. This is how it worked: 
  •   Municipality borrowed money from Bank 
  •   Municipality hedged the interest rate expense (usually linked to Euribor+Spread) by entering into a swap with Dexia.
  • In the swap, Dexia paid to the Municipality the Euribor+Spread and in return received a Structured Coupon.

The catch is in the Structured Coupon. Most of the strategies employed to reduce the cost of funding for the Municipality were simple. Euribor rates for most of the last decade  hovered around 2-3%. Hence, the selling pitch involved trying to hedge any increase in the Euribor rates and finance this by selling options on rates coming down. This they did, and in many cases they did with large leverage. As the crisis unfolded, the unthinkable happened- rates went down to almost zero triggering this options on a massive scale. Some of these can actually cause losses much bigger than the notional of the loan they are suppose to hedge (i.e. Loan 100mln, hedging loss 200mln).

Most municipalities do not mark to market these swaps and do not give collateral to Dexia. On the other hand Dexia needs to provide collateral and mark to market with the Investment Banks that have the back-to-back hedging. This asymmetry of collateral and hedging causes many untold losses. It also speaks volume for the hidden debt losses of Municipalities across Europe. We got glimpses of this practice last year in Italy with the City of Milan litigating against major investment banks.
Although it is easy to blame the European Periphery debt crisis and attribute the losses to their Greek bond holdings the truth is that many European Banks have far deeper structural problems in their portfolios than most admit. Exactly this is the crisis that European politicians need to tackle. After all experience has proved that it is cheaper to save countries rather than banks.