The grim reality that bad loans at Spanish banks hit 178.6 billion euros (or 10.5% of total loans) in August was fairly well publicized. This probably has to do with the fact that the country has been the thermometer for gauging the health of the eurozone since yields on Spanish debt spiked to alarming levels in late July, threatening the country's access to the bond market and in the process destabilizing the entire region and prompting the ECB to cobble together a new bond buying program. In other words, Spain is the next domino and it is wobbling.
Due in no small part to the high drama in Spain, the focus has shifted away from Italy in recent months. Investors shouldn't forget about the Italians however as the situation there is far from stable. In fact, at 10.7%, the percentage of bad loans to total loans at Italian banks is higher than it is in Spain. Non performing loans to total loans in Italy are the third highest in the eurozone behind only Ireland and Greece.
Given this, one might expect the Italians to consider the so-called 'bad bank' approach adopted by Ireland and, more recently, Spain. As it turns out, the Italian Treasury had indeed been in talks with restructuring advisers regarding the feasibility of the bad bank model. In a fantastic example of tragic irony, the Treasury decided the idea wasn't a good one because ultimately, they don't trust the quality of the debt they issue.
The plan, according to Bloomberg, was to take between 30 and 100 billion euros in bad debt off the books of Italian banks and replace it with Italian government bonds. According to Bloomberg's ubiquitous "people with knowledge of the matter", Italian officials believed that saddling the banks with a mountain of Italian government bonds risked strengthening the poisonous link between the banks and their sovereign. From Bloomberg:
The decline in Italian bonds since the outbreak of the debt crisis three years ago has weighed on the earnings of the country's banks, the biggest holders of the nation's debt.
The implication then, is that in the event the sovereign debt market once again turns against the periphery, it could actually be worse for both Italy and its banks if the financial sector held government bonds as opposed to non performing loans. Not exactly the kind of confidence-inspiring message you want to hear from the Italian Treasury department.
The question investors should be asking themselves is: "If the institutions issuing these bonds don't trust them, why should I"? Investors should stay short periphery debt and play for continued weakness out of Europe.