Italian Bank Update

Italy is coming closer to the inevitable government bailout of the world’s oldest bank Monte Dei Paschi. The situation was always bound to happen at some point, but the actual nationalization process could start in the next few days. I mocked the possible loophole on how the Italian government will be able to bailout Pasche without violating the European banking rules because it’s called a “precautionary capitalization.” As I will describe in this post, the parties involved in trying to help recapitalize the bank and get the bad loans off its balance sheet are balking at it now because of the political risk. The Italian government getting involved is the last resort, so this action is anything but precautionary.

The rescue of Monte Dei Paschi is like a jigsaw puzzle as there are many pieces trying to fit in. Most of the pieces haven’t been working out which is why the stock was halted after being down 10% early in the day. The bank is now only worth about $500 million. As I mentioned in the last article, the bank was trying to raise 5 billion Euros in private investment. Bankers with knowledge on the matter only expect it to reach 2 billion Euros from the debt to equity conversion. Wednesday is the deadline for retail junior bondholders to agree with the debt for equity swap. This part of the capital raise was supposed to be 2.5 billion Euros with the rest coming from a 1-2 billion Euro investment from Qatar’s sovereign wealth fund and a rights issue to investors.

The Qatar fund is balking at the potential investment because of the political uncertainty in Italy. This balking is reminiscent of Atlante balking at funding the 4.7 billion Euro bridge loan put together by JP Morgan and Mediobanca. JP Morgan has taken criticism for making big profits on the deal given the stress Italy is in. It’s not a surprise everything is falling apart because it was created by Mario Renzi (former Prime Minister of Italy) in collaboration with Jamie Dimon (CEO of JP Morgan). It would have been tough to get done with Mario Renzi in office, so it’s impossible to get it done without him. He put forward the referendum (which he ended up losing) to get reforms passed so uncertainty would be removed and outside investors would feel comfortable backstopping the Italian banks.

Monte Dei Paschi had claimed its 10.6 billion Euro liquidity position could last 11 months, but now it only is expected to last 4 months. The bank is a money pit. It is the equivalent of a person who borrows money with no ability to pay it back. In this case the person would eventually go bankrupt and learn his lesson. By not allowing banks to fail, the system is filled with zombies. It is the definition of a moral hazard. This time the zombie will finally die in the government assisted private market as the Qatari cash influx was an anchor investment which would boost confidence in the bank. Without the anchor, smaller investors lose faith.

My prediction in my last article will hold true as the Italian lower house of parliament approved the government’s ability to borrow up to 20 billion Euros to support the banks. Monte Dei Paschi is Italy’s third largest bank and has over a third of its loans consisting of the nonperforming variety. Monte Dei Paschi has 27.7 billion Euros in these nonperforming loans, which will be separated from the bank when it is nationalized. The goal will be to get the loans off the books and start fresh. In a year or two the Italian government would like to sell the bank back to the private sector.

Solving this problem is merely a symptom of a larger problem which will eventually boil over. It’s not surprising that the banking system in shambles when the economy isn’t growing and an inefficient court system makes it difficult for banks to collect collateral to recoup bad loans. The problems are a catch 22 because the banks need a strong economy to recover, but they aren’t lending because the economy is weak and they want to be conservative with their lending standards because they have been snake bitten in the past.

Low interest rates are also crimping operating margins. However, the ECB has to do QE to maintain stability. This is another catch 22. If interest rates are low, Italy can survive while having a high debt to GDP, but the banks are weak. If the ECB stops QE and Italian interest rates rise, deficits will increase dramatically and the country will have to cut spending. Sure, net operating profits will improve for the banks, but non-performing loans may increase more if the government cuts benefits. At the end of 2015, the Italian banks had 18% non-performing exposure and 12% non-performing loans. Italian non-performing loans are the highest in Europe.

The country is going in the opposite direction of what is necessary to solve the symptoms because increased political risk will make saving the banks tougher. However, if the right politicians come in charge, the system can be reformed. Going forward, there is high political risk to using Monte Dei Paschi as a model to fix all the banks because the fix is taking advantage of a loophole which the Germans may try to close. As I mentioned in the beginning, the “precautionary capitalization” allows the retail bondholders to not have to take any losses in a government bailout. The loophole is meaningless in one sense because whether the tax payers pay for the bailout or the retail bond holders take a haircut as part of bail-in, money is being taken from the same people. However, when the Germans helped craft this law, they were trying lower the cost of bailouts because they end up being on the hook for Italy itself if it needs a bailout.

Conclusion

I’d say the situation is status quo for the Italian banks. The situation is highly unstable, but that has been the new normal for Italy since the financial crisis. The uncertainty I have is if there is any contagion effect on the other banks. Unicredit is the whale in the room which would be a domino which could knock down the Italian economy.

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1 Comment

  • Sib Ghosh

    December 22, 2016

    What about our ( USA ) bank Big banks are making new high everyday .Is that for real ?