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Dexia Distress Lingers

While Dexia Group has a substantially reduced its footprint in the U.S. municipal market, its lingering financial woes are still a thorn in the side for some bond issues exposed to the troubled Franco-Belgian lender.

Municipal market participants this week are digesting reports that Dexia is in need of a second bailout by France and Belgium and the news that Moody’s Investors Service is considering downgrading the lender.

While some investors said they are avoiding bonds that still have a Dexia connection, most said the impact of Dexia’s problems on the overall muni market is muted because most affected issuers have, by any means necessary, already dumped the guarantor.

Once the fourth-largest letter-of-credit provider in the muni market, Dexia currently has about $10 billion of outstanding letters of credit and liquidity facilities, down from over $54 billion at its peak in 2008, according to Bank of America Merrill Lynch.

“At the granular level, if you’re a portfolio manager, you want to avoid it because you don’t know how it’s going to play out,” said Thomas Jacobs, a senior credit officer at Moody’s. “But in terms of the overall impact on the muni market, Dexia’s exposure is under $10 billion in a market that’s $300 billion-plus in LOC-supported muni transactions.”

David Kotok, chief investment officer at Cumberland Advisors, said he is avoiding any exposure to Dexia in separately managed accounts. “We view Dexia risk as part of a risk-management process, just as we do for a hurricane,” Kotok wrote in a note. “Get out of the way and hope nothing bad happens.”

Dexia and its three main operating units were placed on downgrade review earlier this week by Moody’s amid concerns the bank would need a second bailout. The first came in 2008 after the lender posted steep losses related to toxic assets, and it continues to struggle with its exposure to Greece and other sovereign credits.

Dexia has been working on cutting it its exposure to the U.S. muni market. It sold its U.S. bond insurance company, Financial Security Assurance Inc., to Assured Guaranty Ltd. in November 2008. Issuers have been working to eliminate their exposure to Dexia, refinancing bond issues backed by LOCs from the lender. That has left fewer Dexia-related issues trading in the secondary market.

“From what I understand, it’s about $9 billion,” a trader in Florida said. “If it were higher than that, the marketplace would probably have more of a reaction toward it. But at $9 billion, I’m not finding many people holding back because of that reason.”

Issuers “are able to replace the liquidity with something else,” because there are other liquidity providers in the market, the trader added. “There are people willing to take on risk. You can find another provider. There are other places to go.”

In the first half of 2011, about 850 letters of credit and liquidity facilities rated by Moody’s expired. Analysts noted in an August report that over 100 Dexia LOCs have expired or were scheduled to expire in 2011. Of those, some two-thirds already have been terminated as a result of substitute facilities or refinancings.

For issuers with LOCs or liquidity facilities provided by Dexia that do not expire until 2012 or later, 80% of borrowers either had refinanced those transactions or replaced Dexia as the provider, or were in the process of doing so. Furthermore, none of those issuers indicated any expectation that they would remain with Dexia beyond the expiration of their current facility, Moody’s noted.

So far this year, many issuers of the bonds backed by Dexia have restructured the debt, including the New York Local Government Assistance Corp., San Francisco International Airport, New York’s Metropolitan Transportation Authority and Denver Public Schools.

“The impact will be case by case, and it’s an important issue for borrowers that have direct exposure,” Jacobs said. “But muni market issuers have been successful in substituting facilities and finding alternatives, so we don’t think there will be large-scale problems for issuers to get out of these facilities.”

Generally speaking, in the first half of the year, higher-rated issuers were more successful in finding extensions or substitutions for LOCs. But Moody’s cautioned that those statistics do not mean lower-rated issuers are stuck with Dexia forever.

“Almost every rated issuer was able to find a solution,” said analyst Robert Azrin. “It was just different in the way they found that solution, whether they extended or substituted their existing bank facility, switched to fixed rated debt, refunded the bonds, or entered into a bank loan.”

Jacobs noted that Dexia’s book was primarily high-quality, and that the bank didn’t do much business with lower-rated credits.

“This is, at worst, a modest negative for the muni sector,” said Matt Fabian, managing director at Municipal Market Advisors, speaking about the impact of Dexia’s review for downgrade on the muni market. “Issuers need time to finish restructuring away from Dexia. At worst, their bonds will become bank bonds and accelerate the process.”

A bailout by France and Belgium could be a plus for bonds involving LOCs and liquidity facilities provided by Dexia.

“A bailout or transfer of Dexia’s public finance exposures to other, presumably more stable institutions would be positive for the affected credits,” Jacobs said. “It would give issuers more time to work through the replacement process. If the exposures are moved to an institution that works well for holders of the paper, it could be a seamless transfer.”

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