Monte Dei Paschi: Another One Bites The Dust

Summary

• The Italian government is to inject €5.4 billion into Banca Monte dei Paschi di Siena (BMPS) becoming the bank’s largest shareholder with almost 70% of capital.
• €28.6 billion in loans to be sold for 21% of their gross book value through securitization vehicles involving the Atlante Fund.
• €4.3 billion in subordinated bonds to be “bailed-in” as new equity.
• Taxpayer-funded bailout is yet another example of the limits of the European Union’s new “bail-in” mechanism.

The Italian government has its plate full these days.

After a botched attempt at brokering a private rescue, Banca Monte dei Paschi di Siena (BMPS) (OTCPK:OTCPK:BMDPY), the world’s oldest bank, became the third Italian bank in two weeks to be bailed out. This should come as no surprise to any avid follower of the financial markets given that the bank has been practically insolvent since at least late 2016.

The bailout highlights the daunting task facing Europe as it attempts to erect a banking union that can wind down insolvent banks without drawing on taxpayer support. Spain’s Banco Popular (OTCPK:BPSEY) was driven by regulators into the arms of Banco Santander (NYSE:SAN) in early June 2017 with the latter launching a €7.1 billion rights offering recently to cover expected loan loss provisions associated with the deal. Banca Popolare di Vicenza (BPVI) and Veneto Banca (VB) were acquired by Intesa Sanpaolo (OTCPK:OTCPK:ISNPY) last week after the Italian authorities agreed to inject almost €5 billion in cash and provide up to €12 billion in guarantees. With no larger financial backer or private solution in sight, this time around the Italian government will directly recapitalize an ailing bank.

Restructuring Plan: picked up where its predecessor failed

The Restructuring Plan 2017-2021 calls for a complete recapitalization of BMPS and a wholesale clean-up of its “bad loans”, the riskiest of the bank’s non-performing loans (NPLs):

• A disposal of €28.6 billion in “bad loans”: €26.1 billion at 21% of gross book value through private securitization vehicles with the participation of the Atlante Fund and the aid of an Italian government guarantee in 2018 (GACS), and €2.5 billion through a separate procedure;
• A recapitalization of up to €8.1 billion which includes a cash injection of €3.9 billion by the Ministry of Economy and Finance (MEF) and €4.3 billion in “bailed-in” subordinated bonds;
• A further potential €1.5 billion injection by the MEF to repurchase subordinated bonds from retail investors;
• An improved credit risk management process designed to bring NPLs down to 13% of the loan book and boost profitability (ROE > 10%) by 2021;
• A comprehensive headcount reduction targeting 5,500 employees by 2021 costing €1.15 billion and other expense optimization initiatives;
• A salary cap of ten times the average employee salary.

These conditions echo those proposed in the original Business Plan 2016-2019 back in October 2016 with several notable differences. While the same amount of NPLs was earmarked for disposal, their salvage value was set at €9.4 billion, or 33% of gross book value, slightly lower than the bank’s total provisions at the time. As expected, these estimates were quite generous. Under the new plan, the salvage value was established at 21% of gross book value, or €5.5 billion, with the remaining €3.9 billion to be booked in loan loss provisions.

Figure 1: Gross (GBV) and net NPL (NBV) exposures as of December 31, 2016

Source: BMPS Q1 2017 Financial Presentation

One can immediately surmise that provisions were underestimated by at least €3.9 billion and that a more accurate coverage ratio for “bad loans” would have been at least 78%.

Both plans called for the same securitization vehicle consisting of two senior tranches (A1 and A2) worth €3.8 billion, a mezzanine tranche worth €1 billion, and a junior tranche valued at €0.7 billion. The Atlante Fund has undertaken to purchase 95% of the mezzanine tranche (7% rate) by December 2017. Once the GACS guarantee is secured for the senior A1 tranche, it will be sold to investors along with the senior A2 tranche (4% rate). The junior tranche will be held by BMPS itself until it is sold to Atlante once the guarantee is obtained.

Figure 2: Securitization vehicle for €26 billion in BMPS “bad loans”

Source: BMPS Restructuring Plan 2017-2021 presentation

The original recapitalization plan targeted a capital injection of roughly €5 billion. Negotiations at the time focused primarily on “bailing-in” subordinated bonds. Whereas the bank was able to secure €1 billion from institutional holders of subordinated bonds, the prospect of convincing retail investors with roughly €2 billion in bonds to follow suit was wishful thinking. There was even brief talk at some point of a potential €1.4 billion investment by Qatar Investment Authority (QIA). After the negotiations fell apart, the final nail in the coffin came in the form of the ECB revising its estimate of the bank’s capital shortfall to over €8 billion. It then became abundantly clear that a taxpayer bailout was the only feasible solution that would prevent bankruptcy. For a more in depth analysis of the original plan and the woes that have plagued BMPS for several years, please click here.

Subordinated Bonds

Alongside the €3.9 billion taxpayer injection, the restructuring plan will “bail-in” €4.3 billion in subordinated bonds at about 97% of their book values. In total, this would raise almost €8.1 billion in fresh equity, with the MEF boasting a 48% share.

Figure 3: breakdown of €4.3 billion in subordinated bonds at BMPS

Source: BMPS Restructuring Plan 2017-2021 presentation

Additional Tier 1 (AT1) securities will be “bailed-in” at 75% of their book value and Tier 2 instruments will be converted at 100%. The Italian government set aside an additional €1.5 billion to repurchase subordinated bonds that were converted into shares under the deal. The holders of these securities qualified for such relief under new MiFID regulations given that they are retail investors who acquired said securities through the BMPS network prior to January 2016. In the likely event that the MEF purchases these shares, it could own up to 70% of BMPS.

Naturally the market for these securities factored in the failure of BMPS in the months leading up to the bailout announcement in late 2016. Some AT1 securities (XS0121342827) saw their prices collapse from over 80% of par in late 2015 to just over 32%. Tier 2 securities such as the 7% March 2019 bonds (XS0415922730) saw their prices fall from 72% of par to just over 42% by the time trading was halted in the security in December 2016.

Figure 4: price trajectory of 7.99% MPS Capital Trust 1 (XS0121342827); AT1

Source: Börse Berlin

Collapsing capital levels

During the ECB Stress Tests of July 2016, BMPS was the worst performing European bank reporting a CET1 ratio of -2.44% under the 2018 adverse case scenario down from a 2015 fully-loaded base of 12.07%. The CET1 ratio began its nose dive in 2016 when it started the year at 11.4% and finished at 6.5%. During this time, the bank’s share price collapsed by almost 88% to just over €15/share reflecting a market capitalization of €442 million just before trading in the stock was suspended at the end of the year. As of Q1 2017, the bank reported a CET1 ratio of 5.8% after it booked a further €308 million in loan loss provisions. The sheer size of the provisions vis-à-vis the bank’s market capitalization before trading was suspended is a clear testament to the dearth of capital at BMPS and the severity of NPLs in its loan book. Investors should also note that the bank had already booked €4.5 billion in provisions in 2016 on top of almost €2 billion in 2015.

The ECB’s Supervisory Review an Evaluation Process (SREP) in 2017 established a minimum CET1 ratio of 9.44% for the bank by January 2018. Following the implementation of the restructuring plan and the booking of the €3.9 billion in provisions, BMPS is expected to report a fully-loaded CET1 ratio of almost 13.5% in 2017.

Does Bail-in truly work?

The Italian government has obtained yet another exemption from the EU’s Bank Recovery and Resolution Directive (BRRD); an expected outcome given the severity of the NPL problem in Italy. As with the two Venetian banks rescued last week, the BMPS rescue included a “bail-in” mechanism for subordinated bondholders and relief for retail investors many of whom are clients of the bank who were mis-sold the securities in the first place.

Not surprisingly, the Italian government also guaranteed two senior bond issuances at BMPS in January 2017 and a third issuance in March 2017 for a total of €11 billion. One of these bonds (IT0005240491) carried a coupon as low as 0.5%. The MEF has authorized a further €4 billion in three-year guaranteed bonds by the end of 2017 which the bank plans to take full advantage of. Again, as we pointed out with the Venetian banks, the government was more than willing to intervene even before the capital injection.

The European experience thus far does not bode well for the credibility of the BRRD in such a nascent banking union. Winding down the mountain of NPLs in Italy seems to require both burden-sharing, as policymakers are fond of calling it, and a taxpayer bailout. In a continent awash with undercapitalized banks, one should not prematurely assume that these bailouts will end soon or that they will somehow be restricted to Italy.

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