Monday, August 27, 2012

Dexia demonstrates bank bailouts are far from over

Surprise, surprise ... it appears that despite assurances by the financial regulators, Dexia is coming back for an additional bailout.

Anyone who is familiar with the bank bailout experience of Ireland and Spain knows the bailout loop:  regulators declare bank solvent; market analyzes bank and concludes it is insolvent; regulators ask for and get a taxpayer funded bailout for bank; regulators declare bank solvent; market analyzes bank and concludes it is insolvent; regulators ask for and get a taxpayer funded bailout for bank...

The point where the bailout loop stops is when the government can no longer afford the next bailout.

This point was reached in Iceland at the beginning of the financial crisis.  As a result, they required their banks to absorb the losses on the excess debt in the financial system.  Currently, they have one of the best performing economies in Europe.

This point was reached in Ireland, but the EU stepped up to provide the cash for the next bailout.  As a result, Ireland's economy is deprived of the opportunity to grow as the capital generated by the economy is primarily used for debt service.

This point has been reached in Spain, but no decision has been made whether the EU will step in to provide the cash for the next bailout.  Will the Spanish government deprive its society of growing economy and ask for an EU bailout or will the Spanish government protect its society and require the banks to absorb the losses on the excess debt?

Regular readers know that modern banking systems are designed so that they do not need government funded bailouts.  Banks can absorb the losses on the excess debt in the financial system and continue to support the real economy.

The reason that banks can operate with negative book capital levels is that through deposit guarantees taxpayers are the "silent" equity partner of the banks.  In guaranteeing the deposits, the taxpayer provides the equity for the bank to continue to operate without the taxpayer having to invest $1 in the bank.

The past few months have been good for Belgium. Like France, the country has benefitted from being part of the euro zone’s so-called “soft core,” becoming a sort of second-best safe haven for investors keen to escape risky states such as Spain or Italy, but unwilling to accept the super-low interest rates offered by the likes of Germany.... 
Yet in a sobering report Friday, Credit Suisse research analyst Michelle Bradley, did some number crunching on one risk still facing public finances: taxpayers’ exposure to Dexia, the banking group that all but collapsed last autumn. 
In fact, Dexia has already needed two bailouts in recent years. In 2008, Belgium, France and Luxembourg stepped in with a capital injection and debt guarantees. Last October, the same trio were called on again as the bank was cut off from funding. The Belgian government acquired the domestic retail unit of the bank for €4 billion, pledged to cover 60.5% of up to €90 billion in bank debt guarantees, and ended up with several other potential liabilities to the group. 
Ms. Bradley tots up Belgium’s total potential exposure (contingent liabilities) as follows:
-          €12.2 billion from its share of the outstanding 2008 guarantees
-          €33.0 billion from its share of the €55 billion in debt guarantees pledged as part of the 2011 rescue and that have been approved by the European Commission. Of those €55 billion, €49.1 billion has been used.
-          An additional €21.0 billion if the full €90 billion in guarantees is approved by the Commission.
-          On top of this, she calculates an exposure of €4.3 billion from a collateral deal the now-nationalized Belgian unit struck with its former Luxembourg subsidiary, plus a €2 billion guarantee to the group’s municipal-bond agency. 
The grand total: a maximum total contingent liability of €72.5 billion. That’s 20% of Belgium’s economic output.
Of course, the odds of the government having to absorb such huge losses from Dexia are minimal. The government acquired assets that offset some liabilities when it nationalized the domestic retail unit of the bank. And it would likely lay claim to some of the €411.1 billion in assets Dexia says it owned as of June 30..... 
Ms. Bradley says the main risk is that the government will have to find new taxpayer money to recapitalize Dexia  if market conditions deteriorate. After all, the bank reported a hefty loss in the first half of 2012, it has significant exposure to Spain and Italy and its Tier one capital ratio on June 30 was a fairly low 6.6%, according to its earnings report. 
“Our concern is that should market conditions deteriorate then it is possible that Dexia will need a further capital injection. In an environment when the market is stressed this would already imply higher yield levels for Belgium. Should Belgium have to raise additional funds to support Dexia this puts additional pressure on Belgium’s debt to GDP ratio and its yield levels,” she says.

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