Dexia Bank is majority owned by the governments of France, Belgium, and Luxembourg. It was rescued shortly after Lehman Brothers imploded in 2008. Dexia is front page news again because it can’t get funding (no one wants to lend it money).

There are similarities between Dexia in 2011 and Bear Stearns in 2008.

  • Both banks are/were heavily reliant on wholesale funding (this means they are reliant upon money market funding as opposed to deposits). In the past 3 months, money markets have moved away from funding European banks the same way they did 3 months prior to Bear Stearns collapse.
  • Both banks were said to have liquidity problems when they really had solvency problems.
  • Bear had assets that were toxic: bad mortgage debt that no one wanted.  Dexia has similar toxic assets: PIIGS debt..
  • Bear Stearns was the first US investment bank to fail in 2008. It took a few months to percolate, but eventually the global banking system locked-up and required $T’s from central banks.
    • Do central banks have the money and political cover to embark on another round of bank bailouts?  We’ll see.

What happens next?

Dexia will likely be split into a “good bank” and “bad bank”.  The good parts will be chopped up and sold to other banks. The bad part will be sold for next to nothing.. Any losses incurred will:
- wipe out shareholders
- wipe out bond holders
- be paid by the taxpayers.        In that order.

But banks in Europe are not in a buying mood –even for a “good bank”.  And that bad bank part —- Belgium is going to be hard-pressed to swallow multi-billion-euro losses right now.. Belgium’s debt : GDP is already flirting with 100%.

Here’s where it starts to look a little scary.   Dexia is leveraged (that’s what banks do) 60:1. For reference purposes, Lehman Brothers was leveraged at 30:1.  The losses from Dexia’s collapse could easily push Belgium’s debt : GDP ratio to 110%. Add another year of budget deficits and voila! Belgium’s debt : GDP approaches Italy with 120%.

But Belgium’s government (more on that in a minute) has relied on Dexia to fund its budget deficits. Now that Dexia is gone and indeed going to be bailed out by Belgium (and France and Luxembourg), the Belgian sovereign balance sheet looks particularly ugly / risky.

There’s more!   Belgium has been without a parliament for nearly 500 days — and the current Prime Minister is about to quit. Belgium’s debt rating will be lowered by year end, and it may yet be forced into the bailout zone with Greece, Ireland, and Portugal. If so, this will mean forced austerity for Belgium.  But how do you negotiate and implement budget cuts & tax increases with no legislature?

It is a safe bet that credit default swaps on Belgian debt are going to ratchet up. Shortly, we can expect Belgium to be supported by the ECB’s back door bond buying (like Italy and Spain).  This further speeds up the pace of deterioration of the ECB’s balance sheet and spreads systemic risk.

The ECB is becoming the ultimate bad bank. And Europe’s financial system is entering yet another new riskier phase.