After the close on Friday, the European Banking Authority did what it does every other year: it released the results of what it calls a "stress test" which is simply an annual exercise in boosting confidence. Case in point, the 2016 edition did not even "test" for Europe's two biggest threats, namely negative interest rates or "Brexit." It also did not test any banks from Greece or Portugal, knowing well what the results would have been. However, in order to retain some credibility, the same test which in previous years passed such failed institution as Dexia, Bankia and Novo Banco, had to fail one bank, and this year the honors fell to Italy's Monte Paschi.
However, as we reported earlier on Friday, the EBA only failed Monte Paschi after the bank announced it had obtained a private bailout from a consortium of banks. The Monte Paschi bailout, a €5 billion capital increase, was unique in several ways, not least representing 5.6x BMPS's market cap.
In a nutshell, the plan can be summarized in the following three steps:
- Increase the coverage ratio for Bad debt
- Transfer all the existing stock of Bad debt (sofferenze) into a securitization vehicle. The senior tranche will be covered by government guarantees, Mezzanine will be bought by Atlante fund and the equity tranche will be transferred to existing shareholders and deconsolidated.
- A €5bn capital increase to remove the negative capital impact from the operation and maintain capital level at the current level of 11.8%.
So far so good, but as Barclays' Marta Bastoni puts it: "one problem is fixed but not easily repeatable."
As Bastoni further writes in a July 31 note, "while the announced capital plan has the advantage of removing risks connected to the transferred NPLs from the balance sheet, and is a private solution, the €5bn capital increase represents 5.6x MPS’s market cap. We see this plan as a small positive for the sector as it reduces the total amount of provisions needed to write-down NPLs to a “market level”. However, we believe that it will be difficult to replicate the MPS plan on a large scale, and with ongoing lack of clarity on an ECB target outcome, we believe that uncertainty over the capital position of the sector as a whole remains."
A key role in the securitization-driven bailout will be played by Italy's paltry, €5 billion bank bailout fund, Atlante, first introduced in April, which will be the buyer of the risky €1.6 billion "mezz" tranche. However, with that particular investment, Atlante will be effectively drained, left with just about €1 billion in "dry powder," not nearly enough to prevent or even materially delay the ongoing Italian bank crisis.
Barclays agrees, saying that the Atlante Fund is unlikely to provide systemic solution.
Atlante is set to buy the full €1.6bn mezzanine tranche of the securitization vehicle. In addition the fund will be granted warrants on issued shares, which gives it additional upside on the operation should MPS shares recover in the next five years. We estimate that the fund has €0.9- €1.35bn of additional resources for the rest of the Italian banking system, which would imply between €13-€19bn of NPLs that can be bought.
The problem is that even with the dramatic leverage extension granted by the chosen securitization pathway, Italy's banks will still need vast amount of fresh capital to offset the deterioration of the biggest risk within Italy's banking system: the hundreds of billions in non-performing loans.
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And while we have covering Italy's NPL crisis since 2011 and have little to add at this moment, let's take a closer look at just how the Renzi government bailed out Monte Paschi... for the third time in the past two years, only this time without direct injection of public sector funds, something which Europe has officially forbidden as of this year, forcing banks to be restructured using bail-ins instead.
In answering the question whether this is a real solution, Barclays believes that "the structure of the deal works well for Monte Paschi because we understand it is designed to remove completely any risk connected to the NPLs from MPS’s balance sheet, and is a private solution." That's the good news.
The bad news: "while the solution is reducing some of the uncertainty around the total amount of provisions needed to write-down NPLs at a “market level”, we believe that it will be difficult to replicate the MPS plan on a large scale and with ongoing lack of clarity on ECB target outcomes, we believe that uncertainty over the capital position of the sector as a whole remains."
Setting aside the question of whether Italian bank risk is contained, we focus on the proposed 3-step plan to de-risk Month Paschi.
Here is the big picture: once the plan is implemented, the company states Monte Paschi would have an NPL ratio of 18% vs. current 34%, no Bad debt on the balance sheet and 40% coverage ratio on the remaining NPLs. Shareholder share value however will be diluted by at least 81%.
The plan will first increase the coverage ratio for Bad debt, second, transfer all the existing stock of Bad debt (sofferenze) into a securitization vehicle. Third, a €5bn capital increase, which will essentially make this operation “capital neutral”. The details as broken down by Barclays:
First step: Coverage increase, also for the NPLs that will remain on the balance sheet.
The first step is to increase the NPL Coverage ratio: For the €27bn Bad debts (sofferenze) category, the company states the coverage should increase from 61% in 2Q16 to 67%. This level of coverage means that the transfer price used for the securitisation will be 33c. In addition, the group will also raise the coverage for NPLs that remain on the balance sheet, that is €18.1bn of ‘Unlikely to pay’ and ‘past due’ loans. The coverage ratio will be increased from 29% to 40% according to the company.
Second step: Securitization structure.
The €27bn of gross Bad debt will be transferred to the MPS special vehicle. The vehicle will have to issue funding on a net basis, so on the €9.2bn of Net NPLs. As a result of the securitization there will be no part of the structure that remains on MPS’s balance sheet. The securitization vehicle will be composed of three tranches:
- Senior tranche : €6bn of investment grade notes that in the plan will be covered by government guarantees (GACS). The group has already arranged a €6bn bridge loan facility to ensure the deconsolidation of the NPLs, and at the same time gives them the flexibility of time to arrange longer term-issuance.
- €1.6bn Mezzanine tranche: to be bought by the Atlante fund
- €1.6bn Junior tranche: will be entirely assigned to current shareholders, who will see the share premium being erased, and replaced by the note.
Third step: the €5bn capital increase
The size of the capital increase is 5.6x the current market cap. The capital injection will be used to cover the capital needs arising from each step of the plan:
- €2.2bn to increase the coverage ratio on the NPL that will remain on the Bank balance sheet up to 40%
- €1bn to increase the coverage ratio for bad debt (sofferenze) to 67%.
- €1.6bn to deconsolidate the equity tranche of the vehicle.
The existing shareholders will see the equity premium on their share replaced by the equity instrument of the SPV. According to MPS the equity tranche should eventually be listed, to facilitate liquidation.
September 2016: Extraordinary Shareholders Meeting and Business plan presented
October / November 2016: Extraordinary Shareholders meeting for the approval of the transaction. We do not expect much resistance from shareholders, as the alternative for the group should the plan not been passed would be bankruptcy and bail-in.
By year end 2016: Capital increase and de-recognition of the NPLs.
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Finally, when looking at the future and whether the existing Atlante bailout structure is repeatable, Barclays conclusion is: yes, but only for small banks.
Atlante is set to buy the full €1.6bn mezzanine tranche of the securitization vehicle. In addition the fund will be granted warrants, on underlying newly issued shares, for an amount of up to 7% of the capital post money, and an exercise price in line with the rights issue. The warrants will have a 5 year maturity. Atlante therefore retains additional upside potential, should the price of the shares recover in the next five years.
Between the equity available for NPL acquisition and the amounts that have been subsequently pledged to the fund, we estimate that today the Fund has at least €2.5- €2.95bn of equity available to buy the junior Mezzanine tranches of the NPL SPVs, which means €0.9-€1.35bn of additional resources for the rest of the system, which using the sector level coverage and the SPV structure for MPS would imply between €13-€19bn of NPL that can be bought. We believe that the Atlante solution could be repeatable for smaller banks, as market capacity may not be able to absorb larger scale increases at the moment.
So to summarize all of the above: Monte Paschi got a private bail-out from fellow distressed banks (to whom the cost of contagion would have been far greater than funding BMPS' bailout) that spared the bank, but wiped out the equity in the form of massive, 80%+ dilution. The problem is that this was a one-off solution - certainly not for other large banks - one which can not be repeated unless further billions are invested in Italy's Atlante bailout fund to capitalize future securitization-mediated rescues.
As to whether other bailouts will be needed, the question then boils down to how credible the EBA's stress test is, and how much faith in the ECB's calculations investors place. Considering that Deutsche Bank has passed every single stress test with flying colors only to plunge in recent weeks to new all time lows, due to both balance sheet fears as well as Europe's NIRP, it is not very likely that investors give too much credibility to what the "stress test" has concluded.
Which then begs the question: how long until the next cycle in Europe's banking crisis - which will likely again be centered on Italy - because while the stress test has come and gone, the biggest secular problem of all, Europe's negative rates and hundreds of billions in bad loans, which are crushing bank revenue and profitability, are here to stay.