The Art of Making Bad Debt Disappear.
By Don Quijones, Spain & Mexico, editor at WOLF STREET.
Markets can move in mysterious ways. Such was the case in Italy last week when the stock of the country’s third biggest and most beleaguered bank, Monte dei Paschi, surged 59%, from €0.17 a share to a totally whopping €0.27 a share, pairing its losses for this year to just 78%. But why?
After all, nothing of real import happened over the last week, apart from an announcement from MPS’s board that it intends to forge ahead with its original plan to bolster capital and sell soured loans. None of which qualifies as new news. Moreover, the announcement did absolutely nothing to dispel the huge doubts that continue to loom over the plan’s chances of success.
The board is expected to announce its latest intentions in a meeting on Monday. Its plan appears to already enjoy the full support of Italy’s government. “I am confident of the business plan that the bank’s management has presented,” Economy Minister Pier Carlo Padoan told Repubblica, adding (tongue presumably lodged firmly in cheek): “Of course with full autonomy.”
Making Bad Debt Disappear
Hatched by advisors from JP Morgan Chase and Italian investment bank Mediobanca, the current plan essentially envisages removing bad loans with a gross value of €27.7 billion from the bank’s balance sheets. This would be done by securitizing the “assets” (i.e. chopping them up and lumping them together into nicer smelling “marketable” asset-backed securities) and then offloading these ABS onto a separate entity at their estimated net value of €9.2 billion.
That entity would be funded by €6 billion-worth of investment-grade notes — i.e. freshly conjured debt — which would be eligible for a state guarantee. In other words, if things go to hell, taxpayers will pick up most of the bill to bail out the bondholders.
The rest of the money will come from a mezzanine tranche of €1.6 billion, to be taken up by Atlante, a bad-bank fund backed by Italian financial institutions, many of them state-owned as we reported last week; and €1.6 billion of junior bonds, to go to Monte dei Paschi’s shareholders. That, in simple terms (ha!), is how JP Morgan Chase and its co-underwriters hope to make €18.5 billion worth of toxic debt vanish into the ether.
Serious Creative Accounting
The other part of the plan to save MPS is, if anything, even more ambitious than the first: to raise €5 billion in fresh capital from shareholders that already lost €8 billion in two previous capital expansions, in 2014 and 2015. Unsurprisingly, most investors are not keen on the idea. So, an alternative plan hatched by Corrado Passera, a former government minister and (in the words of of The Economist) “ex-banker,” is now under serious consideration by the board.
In all likelihood, it was this revelation that drove Monte dei Paschi’s shares to surge nearly 60% last week. Put simply, investors are clinging to the hope that an even more creative, less costly solution can be found to forestall Monte dei Paschi’s collapse, or a full-blooded taxpayer-funded bailout.
Passera’s proposal is particularly enticing, since it would tap investors for only €3.5 billion, while somehow squeezing €1.5 billion from “future earnings.” In other words, MPS, a bank that has been losing money hand over fist for years and whose balance sheet has the highest bad-debt ratio in Italy, the country with the highest bad-debt ratio in Europe (17% of all bank loans are nonperforming), will be able to raise capital today by drawing from its massive pool of earnings in the future.
Now that’s what you call serious creative accounting!
This, it is believed, will be enough to avoid having to bail-in MPS’s subordinate bondholders, many of whom are small-time retail investors that were “missold” complex bank debt instruments during the height of Italy’s sovereign debt crisis (2010-2012). For Matteo Renzi to have any chance of winning the make-or-break national referendum on constitutional reform on December 4, it is essential that these retail investors are not hung out to dry — at least not until after the referendum.
Investors’ hopes may also have been momentarily raised by the news last weekend that shareholders had given their approval to the merger of two large former cooperative banks, Banco Popolare and Popolare di Milano, which will create Italy’s third largest lender, displacing the ever-shrinking MPS. It will be the biggest bank merger in Italy since 2007, when Monte dei Paschi recklessly splashed out €9 billion to take Banca Antonveneta SpA off a very grateful Banco Santander’s hands.
The plan to merge the two banks is eerily reminiscent of the ill-fated creation of Spain’s frankenbank Bankia, the spawn of the doomed merger of seven insolvent saving banks. As Mike “Mish” Shedlock points out, merging troubled banks does nothing but create a big mess out of smaller messes.
In the meantime, Italy’s economy remains deep in the doldrums. On Friday ratings agency Fitch cut its outlook for the euro zone’s third-largest economy, citing weak growth, high debt and the uncertain outcome of the planned referendum, which is now too close to call. “Even in the event of a ‘yes’ vote, Italy would face elections by May 2018, with populist and Euroskeptic parties currently performing well in opinion polls,” Fitch said.
But the biggest threat remains the €360 billion or so of bad debt putrefying on Italian banks’ books. The issues with Italian banks have gotten so bad that they are even keeping some hedge fund partners up at night, said Joseph Oughourlian, co–founder of Amber Capital. The biggest concern, he warned, is the risk of contagion, as some of the better capitalized banks are “called on by the regulators and by the Italian government to help the weaker players.”
Against such a grim backdrop, it’s hardly surprising that domestic and foreign investors continue to vote with their feet. So far this year, a staggering €354 billion has been pulled out of Italy – up €118 billion from the same period last year. Worried investors are fleeing with their cash, driven by worries that the banks’ existential problems will continue to deteriorate as political deadlock in Rome and new banking regulations in Frankfurt prevent a comprehensive solution — assuming there is one — from being found.
Instead, the authorities — both political and monetary, domestic and European — will continue to resort to the tired old playbook, deploying quick fixes (e.g. mergers of bankrupt banks) and accounting gimmickry (e.g. allowing insolvent banks to use “future earnings” to fill today’s gaping capital shortfalls) to address, or as least conceal, a problem that threatens to engulf not only Europe’s third largest economy, but the entire Eurozone with it. By Don Quijones, Raging Bull-Shit.
€4.8 billion window-dressing to cover a growing €360 billion hole? Read… Why Italy’s Banking Crisis is Spiraling to Heck