Italy On The Brink

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Douglas Adams


  • With the Renzi government's resignation, the frailty of Italy's banks is thrust to the fore with Monte dei Paschi di Siena's (BMPS) pending "precautionary recapitalization" under EU bail-in rules.
  • The EU bail-in rules provide for an 8% threshold to be met before the use of public money is allowed, potentially including small retail investors and depositors in the plan.
  • A similar bail-in of four small banks in the spring of 2015 produced widespread protests. While the BMPS losses are not systemic, the political fallout could become toxic.
  • Italy's Constitutional Court will rule on Italicum that went live in July. The lopsided referendum loss places Italy's electoral rules in a state of flux, heightening political uncertainty.

In the land that gave the world opera, Italy is no stranger to drama. On the political side of the coin, the crushing defeat of Italy's constitutional reform has precipitated the resignation of Prime Minister Matteo Renzi's government. No surprise here - Renzi was very transparent on the possibility. Markets appeared at first glance to have taken the event in stride. Turmoil nonetheless erupted almost immediately in Renzi's Democratic Party as members price in the extent of the political damage that has ensued in the referendum's wake. With the unmistakable smell of political blood in the water, there have been loud calls for snap elections from Italy's reinvigorated, high-flying populist parties - the 5 Star Movement, the Northern League and Forza Italia that between them now command close to 60% of the electorate as measured by the referendum's results. Italy's cautious, soft-spoken 75-year-old patriarchal president from Sicily, Sergio Mattarella, is charged with sorting out the wreckage.

The argument against holding snap elections in the spring of 2017 pushes from a variety of directions, with the need to wait for Italy's Constitutional court to rule on the so-called Italicum reforms that passed last year and went live in July heading the list. The Italicum is controversial in that the plan awards bonus seats to the winner of parliamentary elections in the Chamber of Deputies, guaranteeing an absolute majority for a five-year term. Yet since the referendum nullified Renzi's plan to largely neuter the Italian Senate, both houses will presumably continue to be elected by the rules of old: Italians over the age of 18 may vote for candidates running for the Chamber of Deputies, but only those aged 25 years or older may vote for candidates running for the Senate.

Italy's bicameral parliament is a peculiar arrangement brought forth by the constitution of 1948 that meticulously sought to constrain the concentration of future governing power in the hands of any one branch of government. The result was a legislative body that scrupulously shared power equally. While the original intent of the constitution was to forever prevent the return of fascism, the result over the years has largely been mixed. Different voting constituencies across cultural and regional divides produced a plethora of political flavors in both houses of parliament that rarely produced a clear governing majority. The Constitutional Court's ruling is due on the 24th of January. Regardless of the current 60%-40% populist-establishment split, electoral contests in Italy will likely remain the partisan, proportional tally of old. That is particularly so in the current uber-populist political environment, where facts become facts with repetition - producing the same broadly based governing coalitions that have so characterized a stunning 65 governments since WWII. These, almost by definition, lack the sufficient electoral mandate and durability to affect the meaningful structural change the country so desperately needs. The last time Italy directly elected its prime minister was back in 2008 when Silvio Berlusconi became prime minister. The country has had three governments since. All were the product of either presidential crisis management (Mario Monti and Enrico Letta) or political intrigue (Matteo Renzi).

And then there are Italy's international commitments. Italy is scheduled to assume a rotating seat on the UN Security Council next year. The country is also slated to host both a G7 summit and the 60th anniversary of the EU's founding Treaty of Rome, signed in 1957. Unlike the UK, Italy is one of the founding members of the EU. The euro is likely to test recent lows on its way to parity with the dollar after already falling just over 4% since the US election.

On the economic side, Monte dei Paschi di Siena's (IT: BMPS) (OTCPK:BMDPY) (OTCPK:BMDSD) "precautionary recapitalization" - complete with losses imposed on subordinated debt holders and possibly deposits in excess of the €100,000 state deposit insurance limit - is likely to be ordered as soon as the weekend. The last strand of hope rested with the Single Regulatory Mechanism (SRM), the regulatory arm of the ECB which could have granted the bank an extension until January, affording the bank more time to explore private funding options. That track was abruptly snuffed out by the SRM late Friday. Investors bailed out of the stock causing the suspension of trading in BMPS shares, which had already fallen 10% in anticipation of just such news (9 December). Italian bank shares on the FTSE MIB Index in Milan fell across the board, giving back most of week's ephemeral, post-referendum gains that saw shares soar 12.6% only to reverse course rather quickly as the stark reality of creditor losses and residual fallout stemming from the BMPS recapitalization loomed large on the immediate horizon as the week's trading drew to a close. For the most part, European markets had largely priced in a "no" vote before the event as did countless polling data - and both guesses proved largely correct. The ECB was fully expected to cover anything untoward on the downside. Still, the lopsided nature of the vote tilted heavily to the surprise side of most measures.

Of course, after the referendum, the Qatar Investment Authority which was slated to put up €1 billion of the €5 billion capital infusion became unsurprisingly squeamish about the idea in the aftermath of a referendum that saw just three of twenty regions manage a plurality of "yes" votes on constitutional reform. The recapitalization of BMPS under the EU's bail-in rules could pose a grave precedent for government policy makers and bankers alike trying to forge solutions to the country's €360 billion non-performing loan pile. While the range of losses at BMPS is estimated to be roughly €10 billion to €15 billion, those losses are far from systemic to the Italian banking sector as a whole in purely economic terms. Still, a similar bail-in of four small local banks in the spring of 2015 unsurprisingly sparked widespread protest, demonstrating yet again that economics arguments rarely guarantee rational popular responses in financial crisis situations - however large or small. That said, the political fallout of forcing losses on an army of small retail bond holders who were similarly sold junior bank debt under the guise of safe, high yielding savings bonds is hard to measure. Even with preliminary talk of compensation, the process could easily turn into a sordid mess that could drag on for years. No politician in his or her right mind would sign on to such uncertainty in front of national elections due in 2018.

BMPS, founded in 1472, is Italy's third biggest bank measured by assets with a stunning €28 billion in non-performing loans (NPL) on its books. The bank's biggest shareholder like most Italian banks is government treasury notes issued by the Bank of Italy - as the relationship between bank and sovereign remains umbilical. BMPS currently trades at €19.50 and carries a book value of 0.38%. Its stock market value is currently about €600 million, down just over 85% through Friday's (9 December) market close. Credit default swaps insuring BMPS' subordinated bonds against default hit a record $4.7 million to insure $10 million of the bank's junior notes for five years, implying a 65% chance of default for the insured period, according to Bloomberg news. The bank has already received two state bailouts and carries the dubious distinction of being the worst performing bank in EU stress tests for three consecutive years. Still, the bank was able to raise (and blow through) about €8 billion in capital on two different occasions, once in 2014 and again in 2015 when the capital markets were more amenable toward distressed banks raising funds and monetary policy flooded the banking system with below market funding through the ECB's Long Term Refinance Operation (LTRO) facility. The borrowing credit was for a period so favorable that even Greek banks were able float issues in the capital markets during the time frame. Now, with the advent of the EU's Bank Recovery and Resolution Directive (BRRD) coming into effect this past January, a direct government funded TARP-like facility is no longer an option to recapitalize either the reserves of distressed banks - or to offload its toxic loan assets. BRRD requires a no-nonsense, straight-up 8% bail-in threshold prior to the use of public funds in any recapitalization scenario. In Italy, the reality is a bit more complicated: Small retail investors and depositors own an estimated €60 billion of subordinated bank bonds in the 15 largest Italian banks. Any resolution scenario where equity prices fall to BMPS levels, senior, junior and possibly depositors with account balances above the €100,000 state insurance threshold could be thrown into the resolution equation. In Italy, this dragnet is politically more suicidal than merely toxic.

Creativity is almost always the mother of invention. Italy has a long history of pressuring larger banks to come to the rescue of their smaller brethren in times of trouble. Following the same pattern, the Renzi government pressured several big Italian banks to fund a private recapitalization fix through a private conduit appropriately named Atlante, appropriately named after the Titan in Greek mythology who was condemned to hold up the sky for eternity after the battle of Titanomachy. The original funding of €5 billion was quickly exhausted with the resolution of Popolare di Vicenza and three other small banks in the spring of 2015.

The next stab at creativity was through the Cassa Depositi e Prestiti (CDP). The state-owned CDP was to purchase NPL assets at favorable rates directly from BMPS using privately raised funds funneled through Atlante which cleverly skirted the thrust of BRRD. BRRD requires assets to be marked to market which implied a state supported subsidy for CDP purchase of NPL assets at more or less book prices. It was the Royal Bank of Scotland (RBS) that explored this paradigm with its £45 billion in direct government funding back in October of 2008. Similar fixes were used in Ireland, Spain and Slovenia. In the RBS example, the scheme attracted a host of EU sanctions for the effort - and supplied much of the inspiration for the BRRD. The reasoning was simple: If banks were in need of state aid to balance their books they were in effect insolvent, which meant that bond and equity holders - not taxpayers - should be the first to share in the losses. Greece, of course, has been an EU program state since its first bailout in May of 2010.

With the defeat of the referendum, the Renzi government was forced to resign. Early on in the campaign, the prime minister unwisely personalized the referendum with a cocky promise to resign if a "no" vote prevailed. Arguably, the referendum turned into as much of a popular vote of confidence in the government as it was a rendering of an electoral opinion on the merits of the constitutional change being proposed. In terms of the BMPS capital infusion, even a "yes" vote would have garnered no more than a 50-50 shot of success. A narrow "no" vote would likely have kept the Renzi government in control, but the odds of a successful BMPS recapitalization plan were proportionately steep. With the actual electoral result, there was little room for the Renzi government to maneuver politically short of quickly standing down. The BMPS private sector deal is all but dead. Other recapitalization plans in the works, particularly €13 billion effort to be announced by UniCredit next week, will likely not happen for the foreseeable future.

The cost structure of Italian banks remains problematic: Italy boasts one of the highest concentrations of branches per capita in the world - 59.6 per 100,000 people, more than twice both the world average of 21 and that of the EU (27.98) through the end of 2014. Those countries with more banks per 100,000 include Bulgaria (60.32), Colombia (256.25), Ecuador (77.07), Spain (7024), Luxembourg (80.37), Mongolia (71.73), Peru (120.67) and San Marino (247.41). The United States has 32.39 banks per 100,000. Under its reorganization plan, BMPS was slated to close 500 of its 2,000 branches and cut about 2,500 jobs by 2019 - less than 10% of its total employee count through the end of 2015. It will likely have a good deal less employees under the EU reorganization plan.

For Italy, not being able to raise capital in the private sector and simultaneously being constrained at the national level by EU bail-in rules is a significant breach of its sovereignty - the price of giving up national control over its currency and monetary policy. Rome is now between a rock and a hard place on the issue - which could very well see the country slip into a deep and secular economic spiral. Rating agencies will be hard-pressed not to downgrade Italian debt across the board. In fact on this score, all eyes are on the second tier Canadian rating agency DBRS which is the only firm to still assign a single-A rating to Italian government debt. It is the same DBRS that keeps Portuguese debt teetering on the investment grade side of the measure-critical for keeping the country's debt in the ECB asset purchase program. The spread on borrowing costs between Germany and Italy continues to widen, despite of the ECB's massive asset purchasing program that has now been extended through December of 2017, albeit at €60 billion rather than €80 billion monthly target. The spread on the 10-year Italian note and the 10-year German Bund has soared over 80% year-to-date through yesterday's market close (9 December). At the same time, political progress on structural reform will grind to a halt as the appointed interim government's mandate will not extend much beyond preparing the country for elections that are not scheduled to be held until 2018 - itself hardly a slam-dunk exercise given the failed referendum vote. The task could stretch out for months after the Constitutional Court's ruling in January. Even under the best of political scenarios, sorting out the electoral rules will not only seat the 66th government since WWII but will likely see Italy's three populist parties assume leading positions in the electoral process - each favoring an Italian exit from the single currency bloc. Unlike the UK whose Brexit vote did not directly involve the euro, an Italian move to abandon the euro would bring about one of the biggest runs on Italian euro-denominated assets in history. Banks both in Italy and on the continent could fall under the resulting deluge. Italy could become the first country to directly threaten the euro and with it the integrity of the currency bloc. Ironically, Italy's hosting of the Treaty of Rome festivities next year could easily turn the venue into a wake.

Simply stated, Italy's sword of Damocles is its twin ills of old - its economy and its banks. Output is now so anemic that the IMF projects Italy not returning to pre-2008-09 levels much before 2025, according to recent news reports. Total factor productivity, or that proportion of output not explained by either capital or labor inputs has fallen by about 5% in Italy since the introduction of the euro. The same measure has increased over 10% in both Germany and France. Much of this decline in Italy is likely due to the same demographic issues faced by much of the developed, post-industrial world - aging workforces and declining birthrates. The decline of corporate spending on labor saving technologies and worker training as well as rigid hiring and firing practices that keeps young, historically more productive workers from even entering the labor force are all part of the equation. Translating this chronic weakness in output to purchasing power, Italy's per capita measure has fallen 11% since the financial crisis as compared with Germany which grew by the same amount over the period. For the French consumer, purchasing power has barely changed for the period, according to Conference Board data.

This is the stuff of the populist electoral appeal. Markets will struggle to price the variable correctly.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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