Italy’s Shaky Bank-Rescue Plan
Posted by hkarner - 5. August 2016
Source: The Wall Street Journal
Effects of deal for Monte dei Paschi di Siena could ripple into other financial institutions
The best that can be said for Italy’s latest plan to rescue its third-largest bank is that it might just work.
Monte dei Paschi di Siena announced on Friday a complex deal that would see it offload €40 billion ($44.7 billion) of its most toxic bad debts—equivalent to around 15% of its loan book—into a newly created privately-funded vehicle, paving the way for the lender to raise around €5 billion in fresh capital.
Without a deal on the table, it is a fair bet that MPS would have been unable to open for business on Monday following a European Banking Authority stress test, also released on Friday, that showed the bank’s entire capital would be wiped out under its adverse scenario. This rescue plan is fraught with risk, but depositors kept their cash in the bank.
Of course, the situation never should have gotten to this point. The full scope of Italy’s banking problems has been clear for years; nine out of 14 Italian banks failed the European Central Bank stress tests in 2014. The International Monetary Fund estimates that systemwide bad debts total €360 billion, equivalent to 18% of all loans.
Ireland and Spain cleaned up their banking systems years ago and are now the fastest-growing countries in the eurozone. Yet Rome ignored pleas from its European partners and international institutions to deal with its bad debt problem before new European Union rules came into force in January. Those rules require creditors to take losses before any public money is used to save banks. Now, its banking problem has become a major risk to the entire eurozone.
True, Rome hasn’t entirely sat on its hands. It has loosened the grip of local political interests over bank boards, which had been frustrating efforts to raise capital. It has also reformed the labyrinthine Italian insolvency system, which made it hard for lenders to restructure bad debts or get their hands on collateral.
But the Italian authorities were slow to order banks to write off bad debts, insisting instead that nonperforming loans were adequately covered by collateral and would in any case disappear as the economy recovered. The result: a prolonged vicious spiral as excessive bad debts left banks reluctant to lend, which damaged the economy, leading to more bad debts.
In reality, the new MPS plan is another attempt to kick the can down the road. Sure, it is designed to draw a line under MPS’s own troubles, the biggest source of systemic risk. But other Italian financial institutions will have to stump up €1.6 billion via the recently-created bank rescue fund Atlante to buy MPS’s bad assets, saddling themselves with a large contingent liability.
Meanwhile, the proposed terms of the MPS bad debt transfer have spooked shareholders in other banks. Although the headline value of 33 cents in the euro represents only a small discount to MPS’s current carrying cost of 37 cents, this falls to just 27 cents when one strips out the €1.6 billion of equity that MPS will theoretically retain in the new bad debt vehicle but which it will write down to zero before passing to its shareholders.
How other banks will deal with what may now turn out to be larger than anticipated capital shortfalls is a problem that Rome has left for another day.
From Rome’s perspective, it had no choice but to address the crisis this way. Any solution that would have resulted in losses for retail investors was strictly off limits for political reasons ahead of a planned Autumn referendum on the government’s constitutional reforms.
That also precluded publicly-funded “precautionary recapitalizations”, allowed under EU rules in specific cases where a bank fails a stress test, but which still requires “burden sharing” by shareholders and junior bondholders.
The bulk of MPS’s €5.1 billion of junior bonds is held by retail investors. When €600 million of junior debt was wiped out as part of the rescue of four small lenders in December, it provoked a political backlash.
Many investors would agree that the constitutional reforms are too important to be put at risk, particularly as Prime Minister Matteo Renzi has said he would resign if the referendum goes against him, raising the prospect of a confidence-destroying political crisis.
Yet Mr. Renzi’s nightmare scenario may yet come to pass unless MPS can persuade investors to inject €5 billion of capital into the lender—nearly six times its market value. In theory, a good investment case can be made: Free of the crippling bad debt charges that have been eating into profits, MPS could deliver roughly €1 billion of annual earnings, which on current European sector multiples might be worth up to €9 billion, suggesting substantial upside for new equity investors.
But does MPS have a business plan capable of delivering the earnings growth needed to justify such a multiple? Its misfortune, and Mr. Renzi’s, is that it must convince investors at a time many are already losing faith in much of the European banking sector amid concerns that excessive regulation, negative interest rates and flat yield curves are undermining margins and destroying their business models.
Over the past week, several European banks including Commerzbank and HSBC have reported disappointing results, reinforcing concerns of a new “doom loop” as the side effects of central bank efforts to stimulate the economy start to outweigh the benefits, potentially causing banks to shrink their balance sheets.
Italy has consistently played for time, but time may no longer be on Italy’s side.