Italy Races To Defuse €200 Billion Bad Loan Time Bomb With "Bad Bank"

When Portugal “surprised” senior Novo Banco bondholders with a €2 billion bail-in late last month, the market got an unwelcome reminder that euro periphery banks are far from “solid.”

Novo was supposed to house the “good” assets salvaged from the wreckage of failed lender Banco Espirito Santo, but as it turned out, a lot of those “good” assets were actually bad, and Novo ended up needing to plug a €1.4 billion hole. Initially, the plan was to sell assets but seizing €2 billion from bondholders ended up being a whole lot easier and far more efficient.

News of the bail-in came just a week after Lisbon announced that a second bank - Banif - would need state aid after running out of cash to repay a previous cash injection from the government.

As we head into the weekend, periphery banks are back in the spotlight, only this time in Italy where PM Matteo Renzi is scrambling to put the finishing touches on a plan to guarantee hundreds of billions of NPLs sitting on the books of Italian banks.

Talks with the EU Commission “have already dragged on for two years,” FT notes and need to be concluded over the next few days lest “the whole initiative should collapse.”

Of course Renzi missed what amounted to a deadline on “fixing” the problem under the old rules governing bank resolutions.

One reason the Novo Banco and Banif bail-in and bailout (respectively) were pushed through in what appeared to be a kind of haphazard, ad hoc fashion was because new rules came into effect on January 1 that would have put uninsured depositors on the hook for losses. The same rules require 8% “of a bank’s liabilities to be wiped out before public money can be used,” FT adds.

In short, creditors at Italy’s banks would need to take a hit before Renzi’s government would be allowed to extend state aid. That is unless Italy can devise some kind of end-around, which is precisely what Renzi is attempting to do now.

“Even if approved, the scheme will not be a panacea for the problems afflicting the banks because Italy will have had to limit the impact of the scheme significantly to comply with EU state aid rules,” FT goes on to note. “While previous discussions had focused on the setting up of a sector-wide bad bank, Italy has now shifted to proposing a lighter-touch guarantee system in an attempt to avoid it being designated by the commission as state aid.”

So “state aid” that isn’t “state aid.” Got it.

"Even if we reach a deal over the weekend it would not be decisive... (the bad bank) should have been done before the new rules came into force,” Renzi said on Thursday, acknowledging that Italy may have missed its window.

Shares in Italian banks have been in a veritable death spiral of late but got a bit of respite on Thursday as news of the potential deal crossed the wires. “The situation is much less serious than the market thinks,” Renzi said, in what is perhaps the surest sign yet that things are indeed very serious. He added that his economy minister is "working miracles" to solve the banking sector's €200 billion euro bad loan problem.

"The recent turbulence around some Italian banks shows that our credit system – solid and strong thanks to Italians’ extraordinarily high household savings – still needs consolidation in order for there to be fewer but stronger banks," the PM wrote in an op-ed for The Guardian. "When the market speaks, as it has done in recent days, it is right that bank executives and shareholders comprehend the need for serious and swift intervention." 

Shares of Monte Paschi - the world's oldest bank - surged 43% yesterday but as Bloomberg's Mark Cudmore notes, the stock is still worth less than 1% of its 2007 peak value.

On Friday, things seemed to be moving towards an agreement. "[We're] working as quickly as we can and we have been working on a continuous basis for months to reach an agreement with the Commission," Italian FinMin Pier Carlo Padoan said in Davos.


So why is the EU suddenly willing to concede to the plan, Cudmore asks? Well first because this is all unfolding against a backdrop of record low interest rates. If rates were to ever rise (chuckle) then these sour loans would turn even sour-er-er. 

Additionally, you might recall that one of the biggest stumbling blocks for Europe during the sovereign debt crisis was the link between the banks and sovereigns. Governments depended on domestic banks to buy their debt, but as borrowing costs rose, the banks took a hit on their government bonds, inhibiting their ability to continuously finance government deficits, creating a decisively negative feedback loop that very nearly drove the PIIGS to the brink of implosion. Well three and a half years after "whatever it takes" and Italy is still sitting on a debt pile that amounts to 133% of GDP. If the banks are saddled with €200 billion in bad loans, they may not be able or willing to roll that debt, which sets the stage for Italian borrowing costs to rise.

Commenting on the EU's about face, Cudmore notes that "the authorities’ ability to change their mind as the situation evolves may temporarily help reassure the markets, but ultimately it could shake confidence in the euro."

Right. And Italy's beleaguered banks aren't out of the woods yet. “I wouldn’t say it is over,” Francesco Galietti, an analyst at Policy Sonar in Rome told The Guardian. “Everyone is giving the government some extra hours to come up with a solution. Once there is a solution, it will either stabilise the situation or things will come sharply down.”