By Gretchen Morgenson and Louise Story
As Europe’s debt crisis has deepened, a recurring question is how much risk it poses to the United States economy, and especially American banks.
While American financial institutions have sought to limit any damage by reducing their loans and thus lowering their direct exposure to Europe’s problems, the recent rescue of the Belgian-French bank Dexia shows that there are indirect exposures that are less known and understood — and potentially worrisome.
Dexia’s problems are not entirely caused by Europe’s debt crisis, but some issues in its case are a matter of broader debate. Among them are how much of a bailout banks should get, and the size of the losses they should take on loans that governments cannot repay.
Among Dexia’s biggest trading partners are several large United States institutions, including Morgan Stanley and Goldman Sachs, according to two people with direct knowledge of the matter. To limit damage from Dexia’s collapse, the bailout fashioned by the French and Belgian governments may make these banks and other creditors whole — that is, paid in full for potentially tens of billions of euros they are owed. This would enable Dexia’s creditors and trading partners to avoid losses they might otherwise suffer without the taxpayer rescue.
Whether this sets a precedent if Europe needs to bail out other banks will be closely watched. The debate centers on how much of a burden taxpayers should bear to support banks that made ill-advised loans or trades.
Many on Wall Street and in government argue that rescues are essential, to avoid the risk of destabilizing the financial system — with one bank’s failure to pay its obligations leading to problems at other banks. But others counter that the rescue of Dexia is reminiscent of the United States’ decision to fully protect big banks that were the trading partners of the American International Group when it collapsed, a decision that was sharply questioned and examined by Congress.
Critics warn of a replay of the financial crisis in autumn 2008, when governments used taxpayer money to shore up troubled companies, then allowed them to transfer those funds to their trading partners to protect those institutions from losses. In using public money to rescue private institutions, these critics say, policy makers effectively rewarded banks that traded with companies that were in trouble, rather than penalizing them, and that encouraged risky behavior.
“The question is did the A.I.G. experience and the bailouts generally contribute to the current situation?” asked Jonathan Koppell, director of the School of Public Affairs at Arizona State University. Would the banks, he continued, “have had a different view in dealing with Greece — or with Dexia for that matter — if those who had dealt with A.I.G. hadn’t been made whole?”
Given the global and interconnected nature of the financial system, institutions around the world have other types of indirect risk to European debt problems. But the scope of these ties is not fully known, because the exposure is hidden by complex transactions that do not have to be reported in detail.
Dexia, which was bailed out by France and Belgium once before, in 2008, is just a small piece of the broader European debt and banking turmoil. But its collapse comes at a critical point, as European officials are meeting this weekend to work out how taxpayer money should be used to resolve the Continent’s debt crisis.
The most acrimonious debate has been over the amount of losses banks should suffer for lending hundreds of billions of euros to countries that may not be able to fully repay. In the case of Greece, big lenders in Europe have tentatively agreed to swallow modest losses on what they are owed, but are resisting proposals that would force them to take a much bigger hit. Even if they accept losses, they may then seek tens or hundreds of billions in capital infusions from their governments.
As the Dexia bailout deal closed last week and was approved by the French Parliament, officials overseeing the restructuring say that the bank will meet all of its obligations in full. Alexandre Joly, the head of strategy, portfolios and market activities at Dexia, said in an interview that the idea of forcing Dexia’s trading partners to accept a discount on what they are owed “is a monstrous idea.” He added, “It is not compatible with rules governing the euro zone, and it has never, ever been considered to our knowledge by any government in charge of the supervision of the banks.”
While several government officials in France and Belgium agree that they expect to allow Dexia to use its rescue money to pay its trading partners in full, others said a final decision had not been made. Representatives for Dexia’s trading partners, like Morgan Stanley and Goldman Sachs, said they were not concerned about exposure to Dexia.
Dexia has suffered in several lines of business, including investments in sovereign debt from countries like Greece. But the biggest drain on its cash stemmed from a series of complex, wrong-way bets it made on interest rates related to its municipal lending business. A significant part of Dexia’s business is lending money to these localities at a fixed interest rate for relatively long periods, say 10 years. But, because the interest rate that the bank itself pays to finance its operations fluctuates, that exposes it to potential risk. If its cost of borrowing exceeds the interest it charges on loans outstanding, it loses money.
To protect itself, Dexia entered into transactions with other banks. But in doing so, it made a major miscalculation and protected itself only if interest rates rose. Instead, interest rates fell, and according to Dexia’s trade agreements, Dexia had to post billions of euros in collateral to institutions on the opposite side of its trades, like Commerzbank of Germany, Morgan Stanley and Goldman Sachs.
Dexia is also suffering losses on about 11 billion euros ($15.3 billion) in credit insurance it has written on mortgage-related securities, the same instruments that felled A.I.G., echoing that insurer’s troubles. In this business, too, Dexia’s problems have been worsened by aggressive demands by some trading partners for additional collateral. According to a person briefed on the transactions, Goldman Sachs, one of Dexia’s biggest trading partners, has asked for collateral equal to nearly twice the decline in market value of its deals. As was the case with A.I.G., Dexia must provide the collateral when the prices of the underlying securities fall, even if they have not defaulted.
In all, Dexia has had to post 43 billion euros to its trading partners to offset potential losses, up from 26 billion at the end of April and 15 billion at the end of 2008. The bank’s need for cash to meet these demands drained its coffers, and contributed to its need for a government bailout. The Belgian, French and Luxembourg governments provided a guarantee of up to 90 billion euros to Dexia, and Belgium purchased part of it outright.
Dexia declined to specify how much money had already gone to each trading partner. A Commerzbank spokesman declined to comment. Jeanmarie McFadden, a Morgan Stanley spokeswoman, said that the bank’s exposure to Dexia was immaterial and that Morgan Stanley had received adequate collateral to cover it. Lucas van Praag, a spokesman for Goldman, said “we have no reason to believe that Dexia will not continue to meet its contractual obligations after it is restructured.”
As for the aggressive collateral calls by Goldman, Mr. van Praag said: “Our dealings with Dexia have been perfectly normal. In an environment of widening credit spreads and increased volatility, collateral calls are to be expected.” The suggestion that Goldman has been more aggressive than Dexia’s other trading partners is “quite odd,” he said, adding: “If collateral is owed, we ask for it.” Mr. Joly of Dexia said the bank did not have “significant issues” with Goldman over collateral owed on some contracts.
Economists and financial players are closely watching how European officials handle Dexia’s financial contracts, which span the globe, to see what that might mean for other European banks that might need government support. As trading partners demand more cash, those demands could consume more of the money put up by the Belgian, French and Luxembourg governments.
“We know what the guarantees are that the government put down, but you don’t know how much the taxpayer will end up paying,” said Paul De Grauwe, a professor of economics at Katholieke Universiteit Leuven in Belgium. “I’m pretty sure there are other banks in Europe that have done similar things and may be caught in the crisis that is now brewing. I don’t think this is an isolated incident.”
It may be difficult for European governments to avoid making bank trading partners whole, especially American institutions, since the United States government paid full value to foreign banks that dealt with A.I.G. and also opened Federal Reserve programs to troubled foreign banks. Dexia, for example, leaned heavily on emergency lending programs created by the Fed during the depths of the financial crisis. At its peak borrowing near the end of 2008, Dexia received $58.5 billion from the Fed.
Some financial players may also argue that since France and Belgium took equity stakes in Dexia in 2008 — as part of the government bailout then — there was an implicit guarantee of the company’s obligations, similar to that of the housing finance giants Fannie Mae and Freddie Mac in the United States.
Walker F. Todd, a research fellow at the American Institute for Economic Research and a former official at the Federal Reserve Bank of Cleveland, said governments were setting a troubling precedent when they bailed out a company and paid its trading partners in full, as occurred with A.I.G. and as might occur with Dexia.
“In the short run, it would help if the authorities would say they refuse to provide publicly funded money for the payoffs of derivatives,” he said. “This is like using public funds to support your local casino. It is difficult to see how this is good for society in the long run.”
