DBRS Downgrades Dexia Entities to A (high) Following Q1 2009 Results; Trend Remains Negative

DBRS has today downgraded all the long-term ratings for the entities of the Dexia Group (Dexia or the Group), including the Senior Long-Term Debt & Deposits ratings for the Group’s three main operating banks, Dexia Bank Belgium, Dexia Crédit Local and Dexia Banque Internationale à Luxembourg, to A (high) from AA (low). The short-term ratings for these entities have been confirmed at R-1 (middle). The trend on all ratings is Negative.

DBRS’s rating action follows Dexia’s announcement of its Q1 2009 results and its progress with its Transformation Plan. The rating downgrade reflects the ongoing challenges that Dexia faces in adjusting to the current funding environment and working down its legacy asset exposures, while remaining profitable throughout the down phase of this extended cycle. Although the Group has strong customer franchises and a leading position in public finance that underpin the current ratings, the Group’s earnings continue to be constrained by elevated funding costs and exposures to legacy assets. DRBS saw positive signs in Dexia’s first quarter results with a return of positive net income, but the results also showed the substantial burdens that Dexia continues to carry. One large burden is getting closer to being lifted with the completion of the sale of FSA Insurance anticipated for the end of Q2 2009. The other asset exposures in run-off remain substantial and will take time to work down, leaving Dexia exposed if markets become more distressed. A lower risk profile and weakening economies are also likely to constrain the Group’s revenue growth. So far, credit performance in the operating businesses has held up, but this could change with a more prolonged downturn. With few alternatives, Dexia is relying largely on Government support in the near-term to bolster its capitalization and further raise its cushion over regulatory requirements.

With the financial markets still disrupted, DBRS sees Dexia facing difficult funding issues given its reliance on wholesale funding. Access to short-term funding is limited. There is still little issuance in covered bonds, although recent central bank action may improve liquidity. Deposit growth is an important avenue that Dexia is pursuing to improve its funding profile, but competition among banks for deposits is elevated by the scarcity of wholesale funding. The near-term solution for Dexia’s funding has come from the support of the Belgian, French, and Luxembourg states (collectively, the States) that are providing a guarantee on debt issuances of the Group. To date, Dexia has issued over EUR 73 billion of debt guaranteed by the States, using up approximately 49% of the maximum allowed under the guarantee. In Q1 2009, the States’ guarantee cost only EUR 80 million, but this will increase over 2009 to an annual cost of EUR 500 million. Dexia does not expect a decline in net interest margin as a result of the States’ guarantee. DBRS views Dexia as having gained some time to generate new funding as part of its Transformation Plan and advance its business model to be able to work in the new environment that no longer has low cost, abundant wholesale funding.

Reducing assets is the other side of the funding issue that DBRS views as also posing a challenge. Dexia is now maintaining the majority of its bond portfolio of EUR 157 billion in run-off, which is approximately 25% of total assets. While this bond portfolio is 99% investment grade and has held up reasonably well throughout the crisis, DBRS notes that economic uncertainty and greater than anticipated market deterioration remain a concern with regard to future returns. This bond portfolio is held in Dexia’s Group Center (GC), which was established to hold all non-core assets including the Financial Products (FP) portfolio from FSA, Treasury activities, FSA insurance (until sold to Assured) and certain other centralized activities. Dexia still has exposure to the Financial Products (FP) portfolio, of which $12.1 billion of the $16.6 billion (approximately EUR 13 billion) portfolio is guaranteed by the states of Belgium and France. Dexia’s losses are limited to $4.5 billion, of which $2.0 billion has been reserved as of Q1 2009.

The Group maintains a core equity base of EUR 17.7 billion on a regulatory basis. After factoring in negative accumulated other comprehensive income (OCI), however, Dexia’s equity capital base is only a modest EUR 5.1 billion, or 0.8% of total assets. Year-over-year, the Group’s equity capital base has declined by 55% from EUR 11.3 billion and 9% from EUR 5.6 billion on a linked quarter basis. The quarter-over-quarter decline in equity can be attributed to additional AFS reserves needed for the bond portfolios in run-off. For regulatory capitalization, Dexia’s Tier 1 capital ratio of 10.7%, which is fully protected from any further losses in the FP portfolio, still provides a substantial cushion. While support from the States has helped Dexia bolster its capitalization and improve its risk profile, DBRS sees improving business performance as critical for Dexia to generate the resources to absorb portfolio losses, elevated cost of risk and maintain its capitalization in the coming quarters.

Putting its Transformation Plan into action, the Group has refocused its businesses on its core client franchises to improve its funding profile and drive core business revenue growth. Dexia has reorganized its operating business lines into Public and Wholesale Banking (PWB), Retail and Commercial Banking (RCB) and Asset Management and Services (AMS), which includes Asset Management, Investor Services and Insurance. DBRS views Dexia as having improved performance in the quarter, generating positive net income of EUR 251 million, a dramatic turnaround from a net loss of EUR 2.6 billion in the prior quarter Excluding FSA Insurance, gross operating income (income less expenses) of EUR 464 million was helped by a 24% drop in expenses on a linked quarter basis. The Group’s cost of risk remained manageable in the operating businesses at EUR 97 million, excluding FSA insurance and the effect of the crisis. The overall cost of risk in the GC remained elevated at EUR 335 million, but was down substantially from EUR 1.1 billion in the prior quarter.

Better business performance was evident in Q1 2009 in PWB, which increased revenues. PWB contributed EUR 198 million of net income, or 79% of the Group’s total net income, an increase of 2.5x from the prior quarter. RCB also achieved solid results due to improved margins in both Turkey and Luxembourg, offset by lower fees and deposit margins in Belgium. Net income in RCB of EUR 156 million increased from EUR 23 million in Q4 2008, helped by a 5% increase in revenues, an equivalent percentage drop in expenses and, a decline in the cost of risk by 80% quarter-over-quarter. For AMS, however, deterioration in the financial markets resulted in a net loss of EUR 128 million, following a net loss of EUR 462 million in the prior quarter versus positive net income of EUR 87 million in Q1 2008. Revenues were down as assets under management, insurance premiums, and assets under administration all declined. The largest driver of the AMS loss was Insurance, which recorded EUR 201 million in impairments and losses in its investment portfolio primarily due to equity market declines.

The Group’s non-operating business unit, the GC, added modest net income of EUR 25 million in the quarter, a significant turnaround from a loss of EUR 2.2 billion in the prior quarter. With the new business segmentation, Dexia implemented a set of internal transfer prices, in which prices are linked to the duration of assets, market conditions and cost of funding, reflecting the actual cost of funding. By providing incentives to grow cheaper sources of funding, such as deposits, and use more expensive funding more carefully, DBRS sees this transfer pricing as an important component in Dexia’s drive to make more effective use of its franchise.

If Dexia makes solid progress with its Transformation Plan, improves the performance of its business lines and continues to generate positive earnings, DBRS would see potential to return the trend to Stable. Additionally, if the covered bond market opens up and Dexia is able to fund itself without a government guarantee, this will be viewed positively from a ratings perspective. However, if the run-off portfolios continue to drag on earnings or DBRS perceives any deterioration in the core franchise, this could lead to further negative ratings pressure.

DBRS has today corrected the ratings for certain preferred shares of the Group. The correction to these ratings corresponds with the downgrade of the preferred shares and hybrids for European banks on 20 April 2009 reflecting DBRS’s view that for banks there is an elevated risk of nonpayment of preferred dividends (which DBRS defines as a default on these instruments) relative to the risk of default indicated by senior ratings than in the past. When the preferred shares were downgraded, the ratings of the preferred shares of certain entities were not appropriately downgraded.

The changes to the ratings have been made, and a comprehensive rating table for the issuer is included below. The 20 April 2009 press release can be accessed by clicking on the link below.

Note:
All figures are in euros unless otherwise noted.

The applicable methodologies are Analytical Background and Methodology for European Bank Ratings, Second Edition, and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.