Belgian Bank Dexia Nationalization Bullish for Markets

EUROPEAN MARKET INSIGHT

AMSTERDAM—After one of the worst quarters for stocks in Europe, the equity markets and the euro managed to stage a rebound last week.

In another week of nerve-racking volatility, the Euro Stoxx 50 benchmark equity index rallied more than 10 percent from the weekly low on Tuesday to close at 2,269 points on Friday, only marginally off the highs at 2,290. The euro dropped to $1.31 on Tuesday, only to rebound to $1.35, closing at $1.34 on Friday.

Dexia Nationalized

This time, most of the volatility was not due to Greece, however. Rumors already abounded during the week that Belgian Bank Dexia would be nationalized by the Belgian and the French governments. This was taken as a positive by markets across the board as a sign that contagion would be contained and that the political class was committed to keep the European banking system solvent.

Yesterday, news from Reuters confirmed that the bank would be nationalized by the governments of Belgian, France, and Luxembourg. The company has been suffering from bad U.S. real estate debt as well as European Union (EU) sovereign debt exposure. Dexia already had received a bailout from the Belgian government during the last crisis, including U.S. dollar liquidity from the Federal Reserve (Fed).

Some healthy assets, such as the Turkish bank Denizbank will be sold and other divisions merged with French banks. The three governments will provide guarantees for a so-called “bad bank,” which will hold around 95 billion euros ($127 billion) in toxic assets. In addition, Belgium, France, and Luxemburg might have to guarantee another 200 billion euros ($267 billion) outside the bad bank for the operation to succeed.

This amount represents more than 55 percent of Belgian GDP and Belgium promptly saw its sovereign rating put on “review” by Moody’s on Sunday. The rating agency said, “The uncertainty around the impact on the already pressured balance sheet of the government of additional bank support measures, which are likely to be needed” was the main reason for the rating action. This move by Moody’s was reflected in the credit markets, where the benchmark 10-year Belgian government bond saw its yield rise from 3.65 percent to 3.98 percent over the week. A rising yield usually indicates that investors demand more compensation for increased credit risk.

Controversy about this particular episode of the European sovereign debt and banking crisis abounds as market commentators noted that Dexia in fact had passed the EU’s banking stress tests just a few short months ago. These tests—akin to the tests carried out in the United States—were designed to reassure markets in the viability of the banking system. In addition, Dexia Bank CEO Pierre Mariani earned 1.95 million euros ($2.61 million) per year in 2009 and 2010 despite failing to prevent the bank from sliding into bankruptcy.

While stock markets rallied, several rating agencies continued to downgrade the credit worthiness of different European sovereign nations and banks that suffer most from the current crisis. Moody’s downgraded Italy (from Aa2 to A2) and U.K. banks—such as Lloyds TSB and The Royal Bank of Scotland—as well as three banks from Portugal. The rationale for the downgrade was concern about funding as well as lack of state support. Fitch Ratings downgraded Italy (from AA- to A+) and Spain (from AA+ to AA-) citing budget problems on the regional level in Spain and a “high level of public debt and fiscal financing requirement along with [a] low rate of potential growth” in Italy leaving the country vulnerable to external shocks.

No Rate Cut

Last week also saw the last rate decision of the outgoing European Central Bank (ECB) President Jean-Claude Trichet who will be replaced by Mario Draghi of Italy. The bank’s decision did not contain many surprises but some market participants were disappointed that there was no cut in the main refinancing rate which currently stands at 1.5 percent, much higher than the Federal funds rate of the Fed at 0.0-0.25 percent.

Nonetheless, the bank did announce a 40 billion euro ($53 billion) covered bond purchase program, which is similar to the popular Quantitative Easing also employed by the Fed, but on a smaller scale.

Given rumors about Dexia, which turned to fact yesterday, the market responded anxiously to sound bites from authorities concerning the financial health of other banks and the commitment of leaders to stabilize the financial sector.

Investors got a boost from comments by IMF European Department Director Antonio Borges who last Wednesday was quoted by Reuters saying that EU officials are discussing a bank recapitalization program for the ailing sector, which is in need of 100 billion–200 billion euros ($134 billion–268 billion) of fresh capital.

He also reaffirmed that the IMF was committed to keep supporting Greece if that country made progress in its effort to curtail deficits, "If there is a second program for Greece, which is the expectation, I think the IMF will definitely participate on the condition that we remain convinced that Greece is on track and the right policies can be put in place, that debt can become sustainable."

Comments he made that the IMF might intervene in the primary and secondary bond markets of the eurozone were later denied by the IMF.