Endgame For Italian Banks

| About: UniCredito Spa (UNCFF)

Summary

We are in an endgame for Italian banks: uncertainty on their solvency, profitability and nonperforming loans will likely fade in one year time.

Either the negative hypothesis of an uncompetitive Italy in the Eurozone is confirmed, leaving little hope for transalpine lenders or a long awaited recovery drives bank stock prices to double.

Whatever the outcome, Italian bank stock prices, assuming a mild/negative assessment of EBA stress tests on Friday, are not going to shoot up during next six months.

Selling upside volatility after the tests on big lenders Unicredit and Intesa should be a lucrative strategy during the second half of 2016.

Once upon a time

Italy has changed since the 1960s. At that time, the second most industrialized country in Europe was proud of its post war success: the country was widely respected as a leading capital goods producer, automobile assembler (with mythical brands such as Alfa Romeo or Bugatti) and military equipment manufacturer and enjoyed the Baby Boom so common in the West after the World War II.

In terms of GDP per capita, these were times of the economic "sorpasso" of the UK visualized by the Bugatti beating the Bentley at the Monte Carlo races.

Dynamic family businesses in Northern Italy were counted among the most innovative and creative in the world and were studied and proposed by academics and consultants as the model to follow, with their owners spent the summers in fashionable Amalfitan villas, in Taormina or at the Cote d'Azur.

Unfortunately, most of this is gone now.

Macro picture and the role of the Euro

The Italian macro picture is difficult to read to say the least. After entering the Euro in 2004, the Italian economy did not enjoy the 2000-2008 boom: it expanded 7% compared with 28% of the Spanish economy, 14% for the French, and 11% for the German.

This low GDP growth was combined with low private debt and high public debt levels. At the start of the crisis, the Italian economy was slow growing and financially conservative; at least, the private sector.

Unfortunately, even if the transalpine country did not enjoy the boom, it did suffer the bust: Italy's GDP fell 7% from 2008 till the end of 2015.

Chart 2

Industrial production had a rather negative evolution after the 2008 crisis too: from a 100 basis in 2010, industrial production index fell to 92 in 2015, compared with 95 for Spain, 99 for France, and 109 for Germany.

Current account balance has been positive during the whole period, likely a combination of slow-growing exports and lack of internal demand, particularly of capital goods. Current account over GDP was 1.91% positive at the end of 2015 according to the IMF.

This pattern of low growth - heavy crises in Italy has been developing since the implementation of the Euro; that is, since Italian companies have been forced to compete with German or French ones without recourse to the lira devaluation, traditional source of competitiveness for the transalpine economy.

Thus, in macro terms, the question seems to be if the Italian economy can survive the brutal competitive environment in the Eurozone after the German internal devaluation in mid 2000s and the Spanish one in 2012. In other words: can Italian cars, heavy machinery, textiles and financial services compete with the German, the French or the Spanish in terms of labour costs and technology?

If the answer is a YES, Italy is poised for an economic rebound. And more important, Italian banks are a historic long investment opportunity; in that case, NPLs formation from the 2012-2013 lending or before may be considered an aberration; once cleaned, and given the low prices of Italian lenders, the upside is very important.

If the answer is NO, the banks' NPLs problem Italy faces nowadays is a shadow of what it will be in the future: the economy deteriorates further, bankruptcies will increase even more, together with unemployment, and no recapitalization or bail in will help Italian lender to overcome their profits hemorrhage. In that case, Italian banks are a forever short.

Chart 1

NPLs and Italian banks

So is this wave of Italian NPLs an aberration on the path of the economic Italian rebound a harbinger of far worse times to come?

Italy has 17% NPL ratio at the start of July 2016, or roughly €360b in bad debts; the highest level among the big Eurozone countries - France, Germany, Spain and Italy.

The increase in NPLs formation has been steeper between the period 2011-2014 and seems to have paused for the moment in 2015; this evolution is notably different from that of other European banks subjected in the past to similar dynamics, particularly Spanish lenders.

In the Spanish case, the pile of NPLs - close to 12% as per July 2016 - has its origins on the uncontrolled lending during the boom and the posterior credit crunch; a sizeable part of the nonperforming portfolio was originated from real estate development activities.

On the contrary, most of "fresh" Italian banks' NPLs seem to have originated AFTER the crisis, during the period 2011-2013; even assuming NPLs might have been hidden after origination for two years, it is very difficult to argue that all these NPLs were generated from lending during the boom that ended in the 2008 crisis.

It must be remembered that fixed capital and real estate investment excesses that took place in Greece, Spain and Portugal did not happen in Italy as the transalpine banking system did not enjoy the boom of the 2000s.

Most likely, most of the NPLs are subsequent, originated during the period 2011-2013 and shown in 2014, 2015 and 2016. That would fit well with the GDP profile of the Italian economy of negative or zero growth during these years.

Thus, these "fresh" new NPLs could be a symptom of a deeper malaise of the Italian economy uncorrelated with the 2008 crisis, which is the lack of competitiveness of the whole Italian economy in the Eurozone after the internal devaluation of Germany in mid-2000s and Spain in 2012.

That would be consistent with an abnormally high level of NPLs formation during 2011-2013, the abnormally high unemployment - increased from 8.4% in 2011 to 11.9% in 2015 - and the growing number of bankruptcies during 2011-2015.Chart 3 Click to enlarge

Stress tests, European politics and stock prices

On Friday, the EBA (European Banking Association) will publish stress tests on 51 European banks. The results could very well be negative for Italian banks, not only distressed lenders such as Monte dei Paschi or the Popolares, but for big retail banks Intesa and Unicredit.

In case of capital shortfall, EU rules force national governments in this order to 1) look for private investors 2) bail in depositors and debt holders or only as a third option 3) directly recapitalize banks.

Private investors do not seem keen to invest money in any Italian lender given the uncertain future they face, and bailing in transalpine banks with local retail depositors and bondholders requires an outstanding dose of political will.

So what does all this mean in terms of stock prices of big Italian banks?

Transalpine banks have been consistently falling since maximums reached in 2015. Shares at big Italian banks Unicredit (OTCPK:UNCFF) and Intesa (OTCPK:ISNPY) have fallen 64% and 42% respectively. The mid-cap Banco Popolare di Milano and Banco Popolare, with well-known management, organizational and financial performance historic problems have fallen 56% and 79% respectively.

Most of the falls have taken place during last 12 months.

The falls seem to be motivated by 1) concerns on future solvency and profitability of Italian banks due to their increasing NPLs holdings 2) concerns on potential recapitalization needs from NPLs losses 3) broader concern on the economic and political stability of the country on the midterm and 3) negative momentum towards the financial sector and European banks in particular.

Taking into account these concerns, we are in an endgame for Italian banks: uncertainty on their future will likely fade in one year time.

Either NPLs keep increasing and the negative hypothesis of an uncompetitive Italy in the Eurozone is confirmed, leaving little hope for transalpine lenders or - an unlikely outcome in our view - exports and internal consumption fuel a recovery that drives bank stock prices to double or more.

Whatever the outcome will be, it is clear from the analysis at this point that Italian banks stock prices, assuming a mild/negative assessment of EBA stress tests on Friday are not going to shoot up during next six months: key uncertainties in terms of solvency, profitability and country stability will remain at least till mid-2017.

Thus, a profitable strategy would be to sell out of the money call option on the most liquid Italian lenders Unicredit (CALL option strike €2.7 Dec. 2016 at €0.1) and Intesa (CALL option strike €2.4 Dec. 2016 at €0.07). With the right leverage, this may be a profitable strategy for a prudent investor… but only after the stress tests are published.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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