Tuesday, September 30, 2008

Public finance, private pain

Rather a frightening trend emerging here. Which are the three European banks most under strain the last few days (Fortis and Glitnir aside)? Dexia, Natixis and Hypo Real Estate. What do they have in common? Parents or subsidiaries with a big line in public finance.

Dexia combines a retail operation with a big franchise lending to public sector clients, and a monoline insurer. Natixis used to own a struggling monoline, and public finance is a business line of one of its parents, Banques Populaires, which, together with Caisse d'Epargne, had to bail out the monoline and now bail out Natixis. Finally, HRE owns Depfa, a Dublin-based bank, which until very recently had a big public sector franchise.

So we had a bunch of banks essentially financing a franchise lending to the public sector, either directly, or through private infrastructure borrowers, using wholesale funding. It should have been a very profitable enterprise, since governments, particularly European ones, are rather wary of defaulting. It's the wholesale funding bit that hasn't been working well the last few days. Banks don't like lending to banks.

I'm not sure we can call this a shoe that's waiting to drop to any great degree. Some of these institutions have co-operative members, retail deposits and deep-pocketed government shareholders. More importantly, government has powers of taxation, which will put a floor on how many loans to government go bad.

But I am going to go slightly further and observe some small similarities with what happened to the monolines, which also used to make most of their money from taking on public sector credit risk. Staid institutions yearning to boost their return on equity strayed out of their franchise but did not subject their funding model properly to the stresses of a different business model.

For the monolines it was the use of ratings agencies to determine their cost of capital rather than the capital markets. For the public finance lenders it has been not communicating their business properly to the capital markets, though I'll accept that telling funding partners any kind of story right now would be rather difficult. Still, let's see how the public sector fares with the loss of this funding source.


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