Why a Foreign Bank Feasted on Fed Funds

The biggest recipient of funds from the Federal Reserve discount window during the financial crisis was a European bank that received a total of about $300 billion in loans, guarantees, and cash infusions from governments and central banks. It also owned a subsidiary implicated in a bid-rigging scheme that prosecutors say defrauded U.S. taxpayers. According to details of Fed lending released on Mar. 31, Dexia, based in Brussels and Paris, borrowed as much as $37 billion, with an average daily loan amount of $12.3 billion in the 18 months after Lehman Brothers collapsed in September 2008.

By aiding Dexia, the Fed kept money flowing into local government projects throughout the U.S. Dexia guaranteed bonds issued by entities as varied as the Texas Veterans Land Board in Austin and the Los Angeles County Metropolitan Transportation Authority. The biggest buyers of those bonds were money market mutual funds.

If Dexia had gone "bankrupt, it could have been a catastrophe for municipal finance and money funds," says Matt Fabian, a senior analyst and managing director at Municipal Market Advisors in Concord, Mass. "The market has extensive exposure to foreign banks."

Overseas banks accounted for about 70 percent of discount window loans when borrowing reached its peak of $113.7 billion in October 2008, according to the Fed's data. The discount window, established in 1914, is known as the lender of last resort. By law, most U.S. branches of foreign banks have access to the discount window, says David Skidmore, a Fed spokesman.

The Fed has kept discount window borrowers secret for 97 years. Last week's disclosures were court-mandated after legal victories by Bloomberg LP, the parent of Bloomberg Businessweek, and News Corp.'s (NWS) Fox News Network.

Dexia, which borrowed $37 billion from the discount window in January 2009, said its loans from central banks peaked at $165 billion in October 2008. That month, it obtained up to $202 billion in debt guarantees from France, Belgium, and Luxembourg, of which the bank tapped a maximum of about $130 billion in May 2009. The countries and existing shareholders also provided Dexia with about $8.4 billion in capital.

The Fed loans have been repaid, according to Ulrike Pommée, a Brussels-based Dexia spokeswoman. Dexia used the Fed's emergency lending facilities to finance U.S. assets only, she says, adding that the bank was one of the biggest backstops of municipal bonds, providing letters of credit or so-called standby bond-purchase agreements—guarantees to buy the bonds if investors redeemed their stakes.

Over most of the last decade, thousands of cities, counties, hospitals, and universities issued long-term floating-rate bonds and paired them with interest-rate swaps to try to protect against higher borrowing costs. The strategy, which relied on banks such as Dexia to guarantee a market for the variable-rate notes, collapsed when investment firms and bond insurers lost their top credit ratings. Demands to back up muni bonds sapped Dexia so much that it was "two days from bankruptcy," Pommée says.

Interest-rate swaps have cost U.S. taxpayers billions. The Denver public school system is looking to borrow $800 million to escape a wrong-way bet on rates because Dexia is declining to renew its credit protection later this month. Pittsburgh and Detroit also have had to restructure debt after Dexia decided not to renew their insurance.

Dexia's lifeline from U.S. taxpayers came as federal officials were investigating allegations that two subsidiaries colluded with others to defraud state and local governments. The Dexia units were among more than a dozen financial firms that conspired to pay below-market interest rates to state and local governments on guaranteed investment contracts, or GICs, according to documents filed in a U.S. Justice Dept. criminal antitrust case against another company, CDR Financial Products. Municipalities buy GICs with money raised by selling bonds, allowing them to earn a return until the funds are needed for schools, roads, and other public works. CDR has denied wrongdoing.

Dexia's Financial Security Assurance division, which has not been indicted, said in February 2008 that its bond insurance unit had received a Wells notice from the Securities and Exchange Commission indicating that the agency plans to recommend legal action in connection with the GIC investigation. While Dexia sold FSA's bond insurance unit, it has said it remains exposed to legal risks because it kept another division of the company.

The bottom line: Fed documents show Europe's Dexia borrowed up to $37 billion in U.S. loans. Some argue it was urgent to keep the bank afloat.

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