Yves here. As regular readers may recall, the European Union’s Bank Recovery and Resolution Directive came into effect in January 2016. Experts deemed it to be disastrously flawed. For instance, it failed to create an EU-wide deposit guarantee scheme, and relies on often-undercapitalized national programs. And rather than have national governments rescue banks, it relies on “bail-ins,” in which shareholders and then creditors take losses as bad assets are written down. But depositors are bank creditors. And as the example of Cyprus showed, bank depositors can take losses in bail-ins.
Many of Italy’s banks are insolvent by virtue of making loans to Italian businesses that went sour. Unlike the US, small and medium sized companies dominate the Italian economy. With Italy’s economy shrinking a stunning 10% post crisis, a fair number of these businesses have failed or would fail if they were to pay their loans in full. From a July post:
Italian banks got sick the old-fashioned way: on lending to businesses in their markets. As a direct result of the damage of the crisis to the Italian economy, many loans went bad; more got in trouble as austerity pushed more enterprises into distress. Italian lenders are regularly accused of cronyism and there no doubt were plenty of cases where sick borrowers were given more credit to make them look solvent. But that’s a common practice. Japan’s banks did that en masse in their post bubble years (a move the authorities later said was a big mistake) and in the US, home equity lines of credit were put into negative amortization routinely (not only by not restricting access to the credit line when they were clearly having payment problems, but also encouraging borrowers to make token payments, like $5 a month, and declaring the account to be current).
The problem with the Italian banks thus isn’t the complexity of the problem; it’s the scale, and the fact that Italy sits in the Eurozone, which has a Rube Goldberg bank resolution scheme that the authorities are unwilling to admit won’t work in practice.
Italian banks have an estimated €360 billion of bad loans, which is roughly 20% of GDP. While the value of these loans is not zero, the losses that need to be taken to clean up the Italian banks are enough to focus the mind. Having Italy’s banks remain in a zombified state means they aren’t giving much in the way of credit to businesses that need it. Italy has a high proportion of small to medium-sized businesses. That makes it particularly dependent on bank lending, so the dodgy banks are a drag on the economy.
Normally, the approach for this sort of mess is the one used in the US savings and loan crisis and in Sweden in its early 1990s bank meltdown: spin out the bad loans into a “bad bank,” where they are worked out to recover as much value as possible. The shareholders of the original bank, now a “good bank” are wiped out as it is recapitalized by the government, and top management and the board are replaced. The good bank is eventually sold.
The impediment is the new banking rules that came into effect in January 2016. Thomas Fazi described at length in February why they are such a train wreck. His overview of the fundamental flaws of the bank resolution scheme:
….a very strict and inflexible burden-sharing hierarchy aimed at ensuring that (i) the use of public funds in bank resolution would be avoided under all but the most pressing circumstances, and even then kept to a minimum, through a strict bail-in approach; and that (ii) the primary fiscal responsibility for resolution would remain at the national level, with the mutualised fiscal backstop serving as an absolutely last resort.
The danger of a bail-in is it is a one-size-fits-all approach guaranteed to cause bank runs. A “bail-in” means that rather than using new money to restore bank equity, shareholders are wiped out then junior creditors if needed, and enough of the remaining creditor funds are forcibly turned into shareholders for the bank to have a decent level of equity. As Fazi points out, it’s a potentially useful tool but a terrible idea as a forced solution. For instance, the first time bail-ins were used was in Cyprus. Those banks had little in the way of borrowed money, so it was depositors who took haircuts. In the case of Spanish banks, many depositors had been persuaded to invest in equity-like instruments that they were falsely told were the same as deposits. That puts them near the head of the line for taking losses in the event of recapitalization. In Italy, some banks have apparently resorted to similar chicanery, but not on the scale that took place in Spain. However, many consumers are investors in bank bonds, so they would be hit in the event of a bail-in. And given the Cyprus precedent, a bail-in of any size should scare depositors, and will lead them to move deposits from weak banks to stronger ones, creating liquidity stress and even bank runs.
It’s not as if Italian officials are ignoring this risk; they’ve proposed implementing a good bank/bad bank structure, and sought emergency relief so they can exceed Maastrict deficit limits to assist their banks. They were told in effect that their problem was not an emergency and they need to follow the unworkable bail-in regime. Renzi was rebuffed by Merkel when Italy tried again in the wake of the Brexit vote, arguing that the situation had become more dire. Merkel insisted that Italy needed to follow the new rules.
Back to the current post. The Germans are letting Italy twist in the wind, which is not just short-sighted but potentially self-destructive. But European politicians have gotten away so long with kicking the can down the road and getting away with it that it appears to have desensitized them to risk.
Forcing unsophisticated retail investors who were sold bank debt they were told was just like deposits to take losses is a prescription for inducing bank runs. So many Italian banks are in similar bad shape than any meaningfully sized ones falling over puts most of the others on death watch, and raises concerns about contagion, most of all to the wobbly Deutsche Bank. But what is most surprising is the political tone-deafness. The Germans are utterly unwilling to admit that their banking scheme (the Germans repeatedly nixed elements that would make it more viable) needs to be tossed out since it will fail when put in practice. Instead, they appear almost eager to test their bright shiny new tools out on Italy. But Renzi has proposed constitutional reforms up for a referendum in early December. He initially said he’d resign if they were nixed and later tried walking back his pledge. And Renzi appears to have mistakenly assumed the Germans would give him a waiver of Italian government debt levels to let him rescue at least some banks, not just to prevent chaos but also to preserve him. However, perversely, if the constitutional reforms fail, that hurts rather than helps the upstart 5-Star movement, which has pledged to exit the Eurozone. So the fact that damage to Renzi would also weaken 5-Star may explain the German refusal to budge. However, 5-Star may be able to put together an anti-Eurozone coalition, particularly given the prospect of EU and Eurozone rules leading to more whackage of unsophisticated savers.
An update on the state of the banks below:
By Don Quijones, publisher of Raging Bull-Shit and editor at Wolf Street. Originally published at Wolf Street
Bank stocks have surged just about everywhere since Trump’s election, with one exception: Italy. In the last month only one large Italian bank has seen its shares rise, and that’s the 500-year old bank at the center of Italy’s banking crisis, Monte dei Paschi di Siena, whose nearly worthless shares jumped to €0.24.
All the Wrong Signals
Shares of Italy’s other large banks have suffered heavy losses. Over the past week alone, shares of Italy’s largest bank, Unicredit, plunged 15%, as did the shares of Banca Popular and UBI Banca. Shares of Italy’s second largest bank, Intesa Sanpaolo, fell just under 10%.
The recent losses compound what’s been a miserable year for Italy’s banking stocks. The best performing stock is the investment bank Mediobanca, which is down a mere 24% for 2016. During the same period, Unicredit has shed over 60%, UBI Banca 65%, Banco Popolare 80%, and Monte dei Paschi 85%.
It’s not just banks’ shares that are flashing all the wrong signals. UniCredit’s five-year credit default swap surged to 221.2 basis points on Friday, meaning it now costs €221,200 to insure €10 million of UniCredit’s debt against default over five years.
A Multi-Headed Hydra
As with all major crises, Italy’s current predicament is a multi-headed hydra. It’s a banking crisis, an economic crisis, a debt crisis, and a political crisis all rolled into one, and all coming to a head at the same time.
Italy’s economy has been in reverse ever since it joined the euro 17 years ago. Since 2007, its GDP has shrunk by a staggering 10%. In the meantime its public debt has continued to grow, reaching 135% of GDP today, the highest level of any Eurozone country with the exception of Greece. And now the yield on Italy’s 10-year bond is on the rise, hitting 2.09% on Friday in a NIRP world, its highest point in over 13 months.
Investors are worried about two things: the very real prospect of a government defeat in the upcoming referendum on constitutional reforms (a subject I covered last week) and Italy’s blossoming banking crisis.
The government’s solution to that crisis has been to create two woefully underfunded, deeply opaque bad banks — Atlante I and Atlante II — whose job it’s been to hoover up the worst of the toxic debt off the banks’ balance sheets. Atlante I and II don’t have enough firepower to steady even Italy’s smallish regional banks, like Veneto Banca, which keep coming back for more handouts, let alone the likes of Monte dei Paschi or Uncredit, each of which has tens of billions of euros of nonperforming loans (NPLs) festering on their books.
Two weeks ago when Giuseppe Guzzetti, a senior Italian banker who helped create the two bad banks, admitted that after six months of frenzied activity Atlante II is already “out of breath.”
Meanwhile, JP Morgan Chase’s last-ditch rescue of Monte dei Paschi continues to flounder, as shareholders who have already lost €8 billion in two previous capital expansions seem strangely reluctant to provide the bank with another €5 billion in fresh capital. That has left MPS and its handsomely compensated rescuers little choice but to unveil Plan Y this week, which essentially involves offering holders of the bank’s subordinate bonds a debt-for-equity swap.
Making Retail Investors Pay
Debt-for-equity swaps are a feature of debt restructuring. Put simply, for MPS to restructure its debts, the current owners will have to be diluted or wiped out. To all intents and purposes that has already happened, as MPS’s stock price has barrel-bombed from over €10 in early 2013 to €0.24 today — a 98% decline.
As for the bank’s creditors, they’re invited to become new owners of the reborn entity, by trading in roughly €5 billion worth of subordinate bonds at remarkably generous terms — 85% of face value for those holding junior tier 1 debt and 100% for those with slightly less junior tier 2 bonds — in return for one billion euro’s worth of equity. It’s a shitty deal and there’s no telling just high or low that equity will go, but it’s probably the best they’ll get.
Normally, subordinate debt is the sole preserve of sophisticated investors. But not in Italy. Almost half of Italian banks’ subordinate bonds are owned by retail investors, a dark legacy of banks using their customers as a piggy bank for cheap funding. Put simply, misselling subordinated debt to unsuspecting depositors was “the way they recapitalized the banking system,” as Jim Millstein, the U.S. Treasury official who led the restructuring of U.S. banks after the financial crisis, told Bloomberg earlier this year.
Now some of those retail investors, many of whom are traditional voters of Matteo Renzi’s centre-left party, are on the verge of being bailed in. It’s Renzi’s worst nightmare, at the worst possible time: the swap scheduled to take place on Nov 28, just 6 days before referendum day.
A Classic Prisoner’s Dilemma
An even greater danger is that the swap fails, as individual bondholders decline to participate in the hopes that other bondholders do, leaving them with a safer bond, rather than iffy equity, in a recapitalized bank that still pays a juicy interest rate. As the Wall Street Journal points out, it’s a classic prisoner’s dilemma. If the swap fails, the EU’s bail-in rules will probably kick in, including the forced conversion of subordinate bonds.
In such an event, the risk of contagion cannot be overstated. Many of Italy’s other banks face very similar problems to MPS. They include Unicredit, the country’s sole global systemically important bank (G-SIB), which hopes to dump tens of billions of euros worth of impaired assets in the coming months as well as raise €10-13 billion in new capital from investors, over double the amount that MPS has spectacularly failed to muster. By Don Quijones, Raging Bull-Shit.
Italy is in the middle of a blossoming banking crisis, and now this. Read… The Global “Populist” Doom Tour Swings to Italy