What Dexia's troubles can teach us

A man enters a Franco-Belgian bank Dexia's agency on Oct. 5, 2011 in Tournai.

Tess Vigeland: Yesterday, France and Belgium moved to bail out one of the biggest banks in Europe: Dexia. A bank that had previously survived a financial stress test. It was considered healthy. But apparently that test just wasn't tough enough. And there are likely more Dexias in the wings. What's going on?

I'm joined by our New York bureau chief Heidi Moore. Hi Heidi.

Heidi Moore: Hi.

Vigeland: So Dexia is this Belgian bank. Europe bailed it out once already. Why do we care?

Moore: Dexia does play a big role in municipal bonds. So when cities here in the U.S. try to raise money, Dexia helps guarantee that debt; it helps make sure that they can actually get the money that they want. And the other problem is that there are a lot of banks in this same situation as Dexia. They hold a lot of debt from Greece, Italy; these countries that Europe derisively called "P.I.G.S." -- Portugal, Ireland, Italy, Greece and Spain. So you can tell what they think of them, right?

Vigeland: Right. Not flattering, in any way, shape or form.

Moore: And we're probably going to see a lot more of this.

Vigeland: Let me ask you this now: Why would so many banks want this debt?

Moore: It's government debt. Like when you have Treasuries in your portfolio, that's zero risk. It's as good as cash, right? So all the regulators said that this was zero-risk debt. And it's kind of like when you go shopping for drinks, right?

Vigeland: OK.

Moore: So alcohol you know is kind of bad for you -- you know to avoid it. Caffeine isn't too great, and you want to have that in moderation too. But you can have all the water you want and not just be safe, but be healthy. And that's what banks thought too. These government bonds were like water to them -- they were safe, they were healthy, they were pure, they were neutral.

I talked to Doug Elliott. He's a former JPMorgan executive who's now at the Brookings Institution. He explained why the banks piled up this debt.

Doug Elliott: European banks loaded up too much on debt from the weaker countries. If you've got something that you're allowed to treat as risk-free, why wouldn't you just pile up this stuff?

Vigeland: Well OK, so then why didn't we test the 'water,' you know, to see if it was going to make the banks sick? And the 'water' here is government bonds, right?

Moore: Right. Exactly. And we were afraid of the answer, basically. So the tests were cautious. They didn't want to say: 'What happens if Greece defaults and we have a massive panic?' Because they thought if we say that, it's going to happen. It's like saying "Beetlejuice" three times, if you remember that old movie from the '80s. If you say, "banking crisis, banking crisis, banking crisis..."

Vigeland: There's going to be a banking crisis.

Moore: Exactly. And so they were afraid to test for something so extreme and now we're obviously seeing the flaw in that.

Vigeland: Well, you know, as we mentioned up top, this feels a lot like 2008. We've got rumors, we've got signs of panic. It seems like there might be a contagion out there. Is this redux?

Moore: It's redux emotionally, but what's interesting here is that we actually what we're dealing with here. If you think back in 2008, we had no idea what those mortgage securities were worth, who was holding them; even the bank executives couldn't explain them. Now we know what the problem is: it is the debt of these troubled countries. And now we just need to know how to contain it and deal with it. So it's not so complicated. But what the two time periods do have in common is we have to drop this belief that some assets are risk-free. Do you remember those toxic mortgage securities?

Vigeland: Oh yeah.

Moore: Who can forget them? They were rated AAA. They were as safe as U.S. Treasuries, like they had no risk at all. So if we learn anything, it has to be this: There is no such as perfectly safe lending.

Vigeland: Great. Oh, these are just lessons we continue to learn the hard way. Marketplace's Heidi Moore, joining us from New York. Thanks so much.

Moore: Thank you.

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