Is the Dexia mess the start of a new financial crisis?

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A man looks out of a door next to the Dexia logo at the corporate headquarters in Brussels on Oct. 4, 2011. (Geert Vanden Wijngaert / AP)

In the clearest indication yet that Europe’s sovereign debt crisis is morphing into a wider, financial sector crisis, a big European bank might be looking at a break up. The talk in Europe is that French-Belgian specialty lender Dexia could be dismantled, with healthy units sold off and other assets dumped into a “bad bank.” None of that has been confirmed yet. But the reports come after Moody’s on Monday warned it could downgrade the ratings of Dexia’s operating units, and the Dexia board asked the bank’s CEO to “resolve the structural problems” troubling the bank. Government officials stepped in to calm investors on Tuesday morning, with the French and Belgian finance ministers pledging to guarantee financing raised by Dexia and protect its depositors.

So is Dexia the new Lehman, the starting gun for a renewed financial crisis? Let’s not get ahead of ourselves. Dexia has long-standing problems – it got bailed out during the 2008 meltdown – so it’s not a perfect poster child of the European banking sector. However, the woes that have pushed it into crisis are symbolic of the pressures facing other European banks today. That means it is possible that other Dexias are lurking in the European banking sector.

UPDATE: Something good may be emerging from the Dexia disaster: It may have woken European policymakers out of their slumber and frightened them into realizing the need to fix their banking sector. There appears to be some movement towards a coordinated bank repair plan for the euro zone. Not many details yet, but even the vague reports boosted U.S. stocks on Tuesday.

Recent concerns about the European banks have been based on fears that they could face significant losses on their holdings of euro zone sovereign debt. Those fears have caused short-term financing to Europe’s banks to dry up, as other creditors try to limit their exposure to Europe. In a worst-case scenario, the one-two-three punch of a credit crunch, a slowing economy and losses on bonds from the PIIGS would tip off a banking sector crisis that could look much like the meltdown on Wall Street that caused the Great Recession in 2008.

Of course, that worst-case scenario has been just that, a scenario. Now enter Dexia. What’s happening at Dexia is an example of just how that scenario could play out. Due to the intensifying sovereign debt crisis, Dexia has had trouble raising financing. That’s no surprise. It took a big writedown on its holdings of Greek bonds, and it still has significant portfolio of debt issued by Greece, Ireland, Portugal, Spain and Italy. The squeeze has become so severe that the board decided drastic steps were necessary.

Dexia is far from the only European bank facing such trials. Moody’s downgraded two French banks last month, mainly because of concerns that they could get hit by Dexia-like financing problems. What all this points to is the desperate need for European political leaders to shore up confidence in their banking system – and that means enhancing their capital so they are better prepared to weather the euro debt crisis.

But the Dexia situation exposes yet another problem facing Europe. Yes, Dexia is being backed by the French and Belgian governments. But investors have concerns about the financial strength of governments in Europe as well. No, France and Belgium are not PIIGS. But what the Dexia case shows is how weak banks in Europe may be reliant on backing by financially weak governments in Europe. That’s not a combination made for building investor confidence.

The best we can hope for now is that Dexia is a one-off train wreck, with the damage contained. But I wouldn’t be surprised if Europe’s debt crisis continues to undermine the financial system in Europe. That could mean more Dexias. And a wider crisis.

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