By Don Quijones, Spain & Mexico, editor 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.