The Big Crackup: How PIIGS Exposure Could Sink Intesa Sanpaolo

| About: Intesa Sanpaolo (ISNPY)

Intesa Sanpaolo (OTCPK:ISNPY) is a banking group resulting from the merger between Banca Intesa and Sanpaolo IMI based in Turin, Italy. It has clear leadership in the Italian market and a minor but growing international presence focused on Central-Eastern Europe, the Middle East and North Africa.

Eighty-six percent of all Intesa's loans come from business customers in Italy, primarily through its Banca dei Territori division. With its massive hoard of customer deposits and dominant retail footprint, Intesa is the Italian Bank of America.

Intesa has been loudly complaining since its stock took a beating in 2011 that it is much better positioned vis-a-vis other European banks due to an increase in their Tier 1 capital ratio, which at 10.7% is one of the highest in Europe. Intesa claims and Spanish banks like Banco Santander (NYSE:SAN) could not be more different and that comparisons between them punish Italian banks like Intesa without reason. I disagree.

Intesa and Banco Santander, along with UniCredit and more (OTC:UNCIF) than half of the major financial players with skin in the PIIGS game share exactly the same risk taking culture. After all, their executives have been training together through a talent exchange program since 1971, under the auspices of the Inter-Alpha Banking Group in Fontainebleau near Paris.

Nor is a 10.7% Tier 1 Capital ratio sufficient to contain the massive exposure that Intesa, UniCredit and other Italian banks have to the PIIGS fiasco.

Let's Talk PIIGS Exposure

UniCredit's exposure to PIIGS as a % of Common Equity was 1,070%, according to the 2011 bank stress test reports. That figure's undoubtedly higher now, as Italian banks are forced to purchase more and more of their sovereign's debt in order to simulate a rising investor demand for Italian debt. The reality is that foreign capital continues to flee Italy.

Yet UniCredit is perhaps the most conservative of the Italian banks sampled. Itensa's exposure to PIIGS as of the 4Q 2011 is 1,638% and is probably on its way north of 2000% by now. Banca MPS's exposure is a jaw dropping 4,666%.

With risk exposure like this underlying Italy's banks, a 10.7% Tier 1 capital reserve is far from comforting.

Moody's Downgrade

Now that Moody's has cut Italian debt is to one notch above junk, Intesa, UniCredit, and Banca MPS are in very real danger of triggering margin calls amounting to a 5% haircut on collateral. (Thanks to SA's Colin Lockey for pointing that one out!) Much of this deteriorating debt has been put up as collateral against cash from the ECB, which in turn has been used to buy up more Italian debt.

Deteriorating Employment And Personal Savings Figures Are Increasing The Real Burden Of Debt

In fact, the vast majority of Italian debt is held by Italian citizens in a manner much the same as the vast majority of Spanish debt is held by Spanish citizens, whose banks sold their nation's debt as a savings product to their own customers and have now posted a litany of public apologies for doing so. This trend is non-sustainable, with Italian unemployment at an all-time high of 11.1%, a steep increase in the number of Italian citizens who are no longer saving anything as their bottom lines continue to shrink, and nervous customers demanding that their funds be redenominated in dollars, Swiss francs, and pounds Sterling.

Sentiment Or Reality?

Intesa's response has been to point out that Italy has:

... good capital bases, balance-sheets and funding capabilities as well as liquidity. The country runs a primary surplus and can boast one of the world's highest wealth-to-GDP ratios ...

"It is clear that current markets are being driven more by sentiment than reality," according to Enrico Cucciani.

Italy's fundamentals are certainly much better than Spain's due to the fact that was no property in Italy, which acts as a brake on Italy's economic contraction. It should be noted, however, that Italy's negative GDP figure has been revised three times this year alone, from -.5% in January to -1.4 in April, to - 2% in July. With the harshest budget cuts still to come, there is little doubt that Italian NPLs (non-performing loans) will continue to increase in sync with the broader deterioration of underlying fundamentals in southern Europe. Investors are beginning to take note of the dire situation of Italy's banks and are re-pricing the risk on Intesa's bonds and CDS accordingly.

Bankrolling The PIIGS

The argument that Italy and Spain shouldn't hang from the same yardarm would gain more traction if Intesa san Paolo and Banca Santander weren't also the #1 and #2 financiers of PIIGS government, business and household debt.

In fact, these two banks have loaned over €828.6 billion to PIIGS in loans to institutions, corporations, retail business, mortgages, and commercial real estate as well as over $111 billion to its sovereigns.

As southern Europe's primary banker, its exposure to the Eurozone debt crisis is tremendous. Taken together with UniCredit and Banca MPS's exposure to consumer and business non-performing loans, which is at an all-time high in Italy, the Italian banking system may not be able to survive another economic downturn without full scale ECB intervention.

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