Trading in Italy’s Monte dei Paschi di Siena bank was halted indefinitely by government regulators late Thursday, after shares fell 7.5%. Markets were reacting to news that the troubled bank’s last-ditch effort to remain solvent had fallen through. The nation’s third-largest bank, the 544 year-old Monte dei Paschi will now be nationalized by the Italian government, in the largest such operation since the 1930s.
Economists across Europe have long feared that the failure of MdP would set off a landslide of Italian bank failures that would in turn plunge the Eurozone into another financial crisis. €360 billion in bad loans are held by Italian banks, one-third of all bad loans in the European Union.
An Ignominious End
This week’s drama marks the end of a nine-year tale of mismanagement and misdirection that saw Monte dei Paschi’s stock price fall from more than €9000 a share in 2007 to €15.08 a share Thursday, when trading was halted.
The end came when Monte dei Paschi’s board failed to sell €5 billion in equity to outside investors by last Thursday’s deadline — an impossible task when the bank ‘s market value is only €440 million. A separate effort to convince junior bondholders to swap €2.5bn of their paper for equity also fell short.
The combined €7.5 billion in funds were needed by MdP to meet ECB capital requirements. A failure to raise at least that much equity by the end of the month would result in an ECB takeover and liquidation of the bank. This would result in not only stockholders and institutional bondholders losing their investments, but also wipe out the life savings of the approximately 40,000 Italian households to whom these bonds were marketed as a safe retirement plan. These “retail investors” hold €2 billion of the €4.5 billion in subordinate bonds issued by Monte dei Paschi. A similar situation last year with four small regional banks led to mass protests and at least one pensioner committing suicide.
HEADING FOR THE DOORS
An estimated €14 billion in deposits were withdrawn from Monte dei Paschi this year through September, before depositors accelerated their run on the bank in recent weeks. Depositors from large corporations to individuals are pulling their money out of the bank to protect it from seizure in a bail-in. Outflows have been so heavy this month, that bank officials had to revise their estimate of when the bank would run out of liquidity. In mid-December, it was estimated that Monte dei Paschi had 11 months of reserves. Massive depositor withdrawals caused that estimate to be cut last week to just four months.
Three Strikes And You’re Out
On December 23rd, the Italian parliament approved an emergency increase in the nation’s debt ceiling by €20 billion to establish a bank rescue fund. The first beneficiary will be Monte dei Paschi. The is the third and last government bailout for MdP. A €2 billion taxpayer bailout in 2009 to plug losses that had been hidden by the bank was followed in 2013 by another €4 billion by the government.
This time, the Italian government, which is already the bank’s largest shareholder, will take complete control of the bank and attempt to return it to solvency. The amount of money from the new emergency bank fund that will go to Monte dei Paschi has not been disclosed, but is expected to be around the €7.5 billion the bank failed to raise last week.
Don’t Call It A Bailout
The Italian government is attempting to skirt ECB bail-in rules that mandate junior bondholders lose all of their savings. By calling the injection of taxpayer money a “preventative recapitalization”, the government can pretend that Monte dei Paschi is a functioning bank that only needs some help with a liquidity crunch. The Germans have voiced skepticism that this is actually the case. While the Italian bailout/preventative recapitalization will not spare shareholders, who will see their stocks go to zero, the plan calls for a forced conversion of debt to equity for bondholders. Institutional bondholders will receive 75% of the face value of their bonds in stock, while “small investors” will get 100% of their bond’s face value in stock.
In a further move, a program will be put into place where these small investors will be able to trade that stock into senior bonds (instead of subordinated bonds). Now the shouting over who is a “small investor” begins.
In addition to getting this plan past the ECB and the Germans, Rome is putting itself in a bind regarding the other Italian banks that need recapitalization. Now, bondholders of every other bank will expect to be bailed out the same as MdP’s bondholders, something the nation cannot afford.
Italy’s Banking System On The Precipice
Monte dei Paschi may be getting a lifeline, but there aren’t enough lifeboats on this banking Titanic to save everyone. The estimated €52 billion needed to bring bad loans in the Italian banking sector down to acceptable levels is far more than the €20 billion bailout fund authorized by parliament. Even if the full €52 billion became available, Italian banks would still face the task of selling off €300 billion worth of bad loans at a huge discount (typically 30% or less of book value).
The ECB wants Italian banks to stop the charades, and mark down their non-performing debt to 25% of face value. This is what Italian distressed debt is selling for on the open market. Some has even been sold at 16% of face value. This “mark to market” of their bad debt will cause the banks’ assets to plummet, perhaps putting them in a position that requires raising equity from outside sources. However, it will also give these banks an actual chance of improving their health by selling some of their bad loans. Three more Italian banks are in the same degree of distress as Monte dei Paschi: Banca Carige, and Banca Popolare di Vicenze and Banco Veneto, which are in the process of merging.
Banks can’t expect much more from the Italian government than the new €20 billion emergency fund. Italy is the most indebted nation in the European Union, next to Greece. This extra €20 billion in deficit spending puts the country’s debt-to-GDP ratio up to 134%.
Denial Buys Future Pain
It is painfully obvious that Italy should have cleaned up its overgrown and underperforming financial sector years ago, when the costs and the pain would have been much lower. Instead, the government and the banks clung to the illusion that everything was fine, and they didn’t need a bailout program like Spain and Ireland. As the saying goes, “Pride cometh before the fall.”
Spain took their medicine in 2012, agreeing to an ECB overseen bail-in of its banks that saw stockholders and bondholders lose their investment in banks that were wound down. A special bank was formed to take on a substantial portion of the bad debts in the Spanish banking sector, and then marked them down and disposed of them. They even set forward a program to reimburse their households that had purchased bonds that had been misrepresented to them, just as Italy wants to do now. Despite the political costs and pain to the population, the Spanish economy is moving in the right direction.
The problem now is that the door has closed on this sort of ECB-administered bailout. In addition, the political landscape in Italy bears little resemblance to that of 2012. The Euroskeptic, populist Five Star Movement is riding high in the polls, often neck and neck with the ruling party. Their platform focuses on the corruption of the government, as well as the rich and powerful, giving no chance at all of further bank bailouts.
They have also promised a referendum to have the nation abandon the euro and return to the lira, seen as a step in regaining sovereignty from the EU (and also allowing Italian governments to devalue the new currency to boost exports and reduce foreign debt payments). This move by the bloc’s third-largest economy would throw the EU into chaos.
The Italian banking sector poses the most danger to the EU than any other factor. Pretending that crisis doesn’t exist is no longer an option. The question now is, how much pain is coming, and how far it will spread.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.