Monte Paschi Plunges As Much As 39% On Debt-For-Equity Fears After Surging In Past Week

After a furious rally in the past week on hopes that Italy's oldest, and most insolvent, bank, Siena's Monte Paschi has turned the corner and would return to profitability while outside investors would finally help it in its seemingly endless quest to find $5 billion in outside capital, today BMPS shares plunged after first opening limit up in what can only be characterized as a roller coast market.

The bank's new CEO Marco Morelli, on the job just 6 weeks, announced he would lay off 2,600 as he targets a profit of 978 million euros in 2018 and 1.1 billion euros in 2019. Monte Paschi is also seeking to dispose of €28 billion of bad loans and is committed to raise as much as €5 billion in capital by the end of the year, with Morelli saying he’ll start talks with potential new investors this week.

Concern over the terms of the recapitalization broke the ongoing euphoria over hopes for profitability, and Monte Paschi jumped as much as 27% before declining 23 percent to 27 cents at 11:50 a.m. in Milan. The Siena, Italy-based lender surged about 58 percent last week, helping pare losses this year to "only" 64%. The bank’s lower Tier 2 notes due in April 2020 rose 6 cents to about 80 cents, the highest level for the junior bonds since Aug. 2, according to data compiled by Bloomberg.

What catalyzed the moves was Morelli's statement during a press conference that Monte Paschi plans to offer debt swap to all €5.1b outstanding bonds, adding that the main goal now is bringing bank back to normal and is “Absolutely open” to examine any proposal for bank. The market interpreted this as an aggressive debt-for-equity swap is imminent, one which could lead to even more massive equity dilution, and the result was show in the chart above.

Earlier, Monte Paschi announced that in Q3 the bank recorded a loss of €1.15 billion, down from a profit of €255.8 million a year earlier as it set aside another €1.3 billion in provisions for soured loans. The common equity Tier 1 ratio, a measure of financial strength, slipped to 11.5% at the end of September from 12% at the end of 2015.

As part of its cost-cutting operation, the bank plans to cut 2,600 jobs by 2019, compared with a previous goal of 2,700 remaining reductions by 2017. As of June 30, the bank counted 25,700 employees. It will shut about 500 branches out of about 1,900 outlets. Under the leadership of Fabrizio Viola, Monte Paschi struggled to reverse a slump in shares, with the bank amassing more than 6 billion euros in annual losses over the past four years.

But while the new CEO's ambitious plan to return to profitability is admirable, mcuh more attention will be focused on the bank's far more pressing balance sheet needs. The bank has been struggling to find €5 billion in fresh capital ever since it failed the latest ECB stress test; the lender announced today it was committed to complete the capital raising by the end of the year, possibly in several tranches, include a debt-for-equity swap and a portion reserved for potential anchor investors. Shareholders will meet Nov. 24 to approve the proposed capital increase.

Monte Paschi is still waiting for authorization for the planned voluntary debt swap, according to Morelli. The swap, whose terms are still to be defined, will involve all the 5 billion euros of outstanding institutional and retail subordinated bond holders, he added. Translation: more massive dilution for equity holders who will be crammed-down by an amount greater than the bank's entire market cap.

Cited by Bloomberg, Miguel Hernandez and Geoffroy de Pellegars, analysts at BNP Paribas SA said that “perhaps the most important disclosure made this morning is the confirmation that retail investors will be involved in the exchange. We expect bonds to stabilize around these levels until we have firm indications of interest in the share sale from institutional investors.”

As Bloomberg notes, the timing of the rescue offering will probably coincide with a vote on constitutional reform in Italy on Dec. 4 that may spark political uncertainty and market volatility. The bank aims to collect bondholder agreements on the swap before the vote to limit the impact on the recapitalization, according to people with knowledge of the plan. Prime Minister Matteo Renzi, who has made revamping Italy’s troubled banking system a key priority, has previously said he will quit if his reform is rejected.

“With the clean-up loss charged in 2016 the key issue of this plan is that we still do not know who is going to underwrite the cash call,” said Fabrizio Bernardi, a Milan-based analyst with Fidentiis Equities. He has a sell recommendation on the shares.

In a recent trial balloon by Italy's Il Messaggero newspaper, the sovereign funds of Qatar and Abu Dhabi, as well as the People’s Bank of China were said to be among investors that may be interested in the capital plan. Corriere della Sera, another Italian daily, reported that the sovereign fund of Kuwait may also weigh an investment. “We’re going to start entertaining talks with potential core investors today,” Morelli said, without elaborating. “We received a number of approaches from different parties.”

Monte Paschi expects a return on tangible equity, a measure of profitability, of more than 10 percent in 2018 from the 8 percent targeted under a previous plan. As part of the overhaul, the lender is disposing of its debt recovery and merchant units, with Istituto Centrale delle Banche Popolari Italiane SpA having offered to buy the latter for 520 million euros.

Monte Paschi’s pains date back a decade, when acquisitions that overstretched its finances and bets on bonds and derivatives by previous managers backfired, forcing the bank to book losses and restate accounts. In 2013, Monte Paschi became the target of national outrage when news broke that it used complex derivatives transactions fashioned by Deutsche Bank AG and Nomura Holdings Inc. to hide millions of euros in losses. In continuing the quiet sweep of the previous management team, the bank said it named Francesco Mele chief financial officer to replace Arturo Betunio who will leave the company on Nov. 25.