Dexia from the bottom up

Industry professionals who lived through a real muniland disaster when the auction-rate security (ARS) market exploded in 2008 have cocked a jaundiced eye at the news that the giant Belgian/French bank Dexia — a big guarantor of American municipal bonds — is on the verge of collapse.

The difference in magnitude of the two events is exponential; Dexia only backstops about $10 billion of U.S. muni bonds — many times smaller than the $400 billion ARS market that froze in February 2008 and helped precipitate the financial crisis.

Nevertheless, both shocks involved the problem of long-term municipal bonds called “variable rate demand notes” (VRDOs) which reset their interest rates every week. Even the rates on the most super-charged adjustable-rate mortgages don’t reset that frequently. Moreover, VRDOs are distinct in that if the buyer doesn’t like the reset rate they have the right to return the VRDO back to a liquidity provider, Dexia in this case, which stands ready to buy the bonds if the buyer doesn’t want them anymore. The possibility that Dexia doesn’t have the capital to buy the $9.6 billion in VRDOs is a big issue.

Reuters is reporting that Dexia has been voluntarily withdrawing from the U.S. market:

“Our exposure (to the U.S. muni market) has been diminished significantly, and that was a deliberate choice on our part,” Guy Cools, general manager of Dexia Credit Local’s New York branch, told Reuters on Tuesday.

The global spiderweb of debt

If you are not familiar with the municipal bond market, you may think that muniland is nothing more than states, municipalities and school districts offering plain bonds that mature on a set date and offer a fixed interest rate. That is the textbook description.

Actually the municipal bond market is a murky tangle of odd bond structures, variable-rate debt, multiple layers of issuers and bank guarantors. The lack of standardization of bond structures and relationships is one of the main reasons that the asset class has never migrated to the internet for retail investors.

Often the odd bond structures can create much more exposure to the tides of global affairs than plain vanilla bonds. The biggest example now is the Belgian-French bank Dexia, which is a big guarantor of U.S. muni bonds.The WSJ reported in an excellent article that investors are selling off muni bonds that Dexia insures:

Muni sweep

Dexia Tower, Brussels It’s a busy morning in muniland. Here are several big stories to get the day started.

Bloomberg’s Bob Ivry has written an excellent expose of why the French and Belgium bank, Dexia, borrowed more from the Federal Reserve in the financial crisis than any other institution.

Why is Dexia important for muniland? Dexia owned a bond insurer, FSA, that provided insurance and guarantees for a big swath of the municipal market. No funding for Dexia equaled no funding for many municipalities. The markets were teetering on the brink and a few semi-solvent institutions kept them afloat. Dexia was one we hadn’t heard much about until now. More to come on this big story.

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