Monte Dei Paschi Is The Key To Europe

If you thought the Monte Dei Paschi story was over, you underestimated the situation. It is only getting started. The results of how this plays out will have wide ranging ramifications for other troubled banks in the future. In the European stress test, the bank came in last place out of 51, so it will be the first to go through the bailout process after the European bailout restrictions were put in place in 2014. It also has major political implications because Germany wants harsh penalties for the bond holders and Italy wants the least possible penalties. Any issue which pits the two countries against each other makes the EU situation worse. The reality is most economic issues fall under this category which is why the European Union will break up.

The key issue with Monte Dei Paschi lies with the junior bonds owned by retail investors. There are a few possibilities which can occur. The decision will be made in Brussels as German politicians and Italian politicians plead their cases. It will take a few months to determine what to do, but if there isn’t a strict enough penalty for bondholders, Germany will get mad because it opens the floodgates for more banks to get bailed out. Italy will argue that this is a one-time issue. Germany is mainly right, but it’s fighting a losing battle.

This situation is like the debt ceiling debate in America. The GOP didn’t want to raise the ceiling, while the Democrats argued that the money was already spent. The GOP was right to want to cut spending, but the Democrats were right that the money was spent; this issue is about fulfilling previously agreed upon obligations. It would be great if restricting bailouts would prevent Italian banks from making risky decisions, but the situation is way past that as the banks already made the bad decisions and are in dire straits. If the restrictions against bailouts were implemented 10 years ago, it may have prevented this scenario from playing out the way it did. The reality is if the Italian banks fail, it will cause a contagion effect on the German banks whether the German politicians want to admit it or not.

The 40,000 retail investors who own junior bonds worth 2 billion Euros are the main issue of concern as the Italian government needs to limit their losses or it will face massive political blowback. The issue is whether the injection of capital is a precautionary recapitalization or a regular bailout. In order for it to pass as a precautionary recapitalization the bank must be solvent, the money must make up the difference identified in a stress test, and injection must be made in the private market.

Germany is pushing for the regulations to be enforced as they are written. This would mean 8% of the banks debts need to be wiped away before the government is allowed to inject capital. This could even include senior bonds taking a loss as well. Italy is pushing for a gerrymandered approach where the least possible pain is felt. In the gerrymandering, the stockholders are diluted, but not completely wiped out. This is likely why the stock is still at $15. There is still a chance it is worth something in a few months from now. The institutional and retail junior bonds will be swapped into equity. However, the 40,000 holders of retail bonds being classified as “mis-sold bonds” will get swapped to the equivalent amount of senior debt.

If you were to put an Americanized analogy to this situation, it would be like if some of the homeowners who were duped into buying houses with a teaser interest rate in the early 2000s were able to stay in their homes. The bailout of these 40,000 holders could be according to their need or according to whether they were actually duped. It’s tough to prove being duped, especially when you live in Italy where no process is simple. It’s much easier to simply prove that you are poor and ask for senior bonds instead of equity.

The question on investors’ minds is what will happen. I think the retail investors will mostly be compensated for any losses. The goal of the decision will be to avoid hurting the retail investors, get Monte Dei Paschi back on its feet as quickly as possible, avoid having the institutional bondholders take a huge hit, avoid Italy having to take out too much debt to help the bank, and maintain the European regulations to prevent other banks from getting bailed out without any losses taken by bondholders. This will be achieved by some loophole which I’m not aware of or maybe the rules will be amended for practicality. The idea that Brussels is even making a decision on this defeats the purpose of the rules. If the rules were real, then the deal would be done by the book with no questions asked.

This situation is like if a child is caught cheating on a test. The rule is that the child gets a zero on the test, but if the child gets a zero he can’t graduate. Therefore, the teacher works out a way for the kid to do a bonus project so he can pass. The question now is the details of the project and whether the child will end up with a D or a C in the class. Italy is the child. The teacher is the politicians in Brussels. Germany is the kid who didn’t cheat. He doesn’t want to see his classmate rewarded for cheating.

The political risk on both sides is big. If Italy gets away with a bailout, the German people will be outraged and call for stricter bailout regulations and possibly Italy to leave the European Union. If the bondholders take a big cut, then Italians will want to leave the EU. The Italian politicians already have pointed at Deutsche bank exclaiming how it will need a bailout in the future as well. The reality is even though I expect a compromise deal to be worked out, the political strains are still there. Even if everything works out successfully, the Italians and the Germans will still resent each other. This is why I see a breakup of the EU as inevitable.

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