The Dexia Bank Collapse Underscores the Fragility of the Global Credit Market and Derivatives

A major bank failure in Europe that began in September didn’t get much press coverage here in the United States. But is bears special mention, because it underscores the fragility of the global credit market and credit default swap derivatives. A victim of the ongoing Greek Tragedy, the Franco-Belgian Dexia Bank failed last month. It had to be bailed out by $6 billion from France and Belgium, and Luxembourg. Inevitably, those bailouts are backed by the “full faith and credit” of their respective governments. Read: French, Belgian, and Luxembourgian taxpayers.

Dexia was formed in 1996 when the Belgian Crédit Communal de Belgique (also called the Gemeentekrediet in Dutch) merged with Crédit Local de France. Their specialty became making loans to municipalities. That is a stable and reliable banking enterprise in good economic times, but very risky when credit markets are in turmoil.

When suspicion about Dexia’s exposure to Greek debt emerged, suddenly all of their short term capital disappeared. Immediately, “Hot money” deposits were suddenly pulled by their creditors. Soon, several governments lined up to bail them out, promising to protect “all investors”. They need to quickly do anything to stop a contagion that could spread to other banks! Governments did their best to soft pedal the bank’s collapse. Once it became clear that the losses would all be quietly covered, the vultures started circling, waiting to strip the bones clean. These included a group of investors from Bahrain, who saw a high yield, low-risk opportunity. (When governments promise to cover a failed bank’s losses, the risk is minimal.) Meanwhile, both HSBC and the Qatar National Bank expressed an interest in gnawing off Dexia’s limb in Turkey.

A few points to ponder:

The bottom line is that we live in a world with tightly-intertwined banking ventures. Their risks are shared, heavily and widely. They also have hundreds of trillions of dollars of derivatives contracts in play on any given day. At present, their Credit Default Swaps (CDSes) are a huge question mark. As I’ve mentioned before in SurvivalBlog, in a perfect world, derivatives are a brilliant device for reducing risk. They are an intricately balanced machine that results in a zero sum gain if all goes well. But when one party goes “poof”, then suddenly a counterparty is left twisting in the breeze. And when an entire nation’s debts go under, the risks are enormous. Buckle up, folks.