Euro Zone: Recapitalization, Bring It On!

It looks like France is stepping up its game! Nope, I’m not talking about the Rugby World Cup. Aside from working on an agreement with Germany to address the debt crisis, France is also helping out Belgium recapitalize Dexia, its largest bank. And for that, euro bulls have policymakers to thank for the huge rally in EUR/USD on Monday!

15-minute Chart of EUR/USD

Now let me give you the lowdown of what’s been happening.

For those of you not in the know, Dexia has been taking up the spotlight recently, but for all the wrong reasons. Reports indicate that as of last June 2011, Dexia’s debt was around 700 billion USD and market junkies say that a huge part of it was because the bank invested so much in the government bonds of SOME (*cough* Greece *cough*) European countries.

To put this into perspective, Dexia’s debt holdings is more than TWICE Greece’s annual GDP figure!

Officials from Dexia announced that it will be selling its consumer banking division to the government. The Belgian government is buying it for 5.4 billion USD, and along with France and Luxembourg, it would provide funding guarantees over the next decade. Reports cite that Belgium will be paying for the bulk of the 121 billion USD cost for guarantees while France and Luxemburg will pitch in 36.5% and 3% of the total cost respectively.

The news helped provide much needed relief in the markets, as bank recapitalization was a major topic of interest in the markets last week.

As I explained in my post last Friday, bank recapitalization basically entails injecting fresh capital into a troubled bank in order to keep it afloat. I mentioned that the three potential sources of funds would come from either bank shareholders, national governments, or the EFSF.

As it turns out, France and Belgium took route number two, and are going to infuse billions of tax payer money. Quite frankly, there isn’t much choice, because letting Dexia default due to undercapitalization could trigger contagion that would spread to other European banks and even American financial institutions.

The nationalization of Dexia highlights the need for the euro zone to recapitalize its banks. As I said, Dexia alone has over 700 billion USD in debt, most of which is invested in euro zone sovereign debt. Now imagine another 10 to 20 banks in similar positions, all of whom could succumb to poor capitalization.

Recapitalizing banks would help shore up their balance sheets and could help keep yields from skyrocketing and prevent a free fall in bond prices. Furthermore, it would help boost investor confidence in a time when anything can spark widespread panic.

Luckily, it seems that European finance leaders are taking a step in the right direction, as French President Nicolas Sarkozy and German Chancellor Angela Merkel committed to the recapitalization of European banks.

Now, the details of the deal have yet to be decided. For one, Merkel has already said that Germany would prefer that shareholders put up more equity, or that local governments begin nationalization before even thinking of tapping the EFSF.

On the other hand, with France more heavily exposed to Greek debt, it would appear that it prefers to draw from the EFSF fund rather than putting up more moolah of its own.

In any case, having the two powerhouse euro zone economies on board is a major victory in itself. Hopefully, this will all lead to a solution that can finally stabilize the euro zone and bust it out of this debt contagion ditch.