Italy's Bad-Loan Alchemy Aims to Turn Toxic Dross Into Gold

  • Government plans to `wrap' securitized pools of soured loans
  • Guarantee means Italy becomes buyers' credit counterparty

Italy’s plan to use securitization to help relieve banks of their soured loans is an attempt to imbue securities backed by non-performing assets with some of the luster enjoyed by sovereign bonds, according to a senior official at the Treasury.

Italy plans to “wrap,” or guarantee, bonds issued out of vehicles set up to pool banks’ non-performing loans. The warranty, which will only be available for the investment-grade notes and for which the vehicle will pay market rates, will give bonds secured by banks’ duff loans a standing similar to that of state debt, Alessandro Rivera, the head of the Italian Treasury’s Banking, Finance and Legal Affairs unit, said in a telephone interview.

“Non-performing loans have an investor market that’s very limited because these types of extremely complex operations are attractive to specialized investors,” Rivera said. “Vice versa, the market of investors in government bonds is enormous, the biggest in the world. With this operation we are transforming the quality” of bonds which have non-performing loans as collateral, he said.

Italy has set no limit on how many eligible bonds it will guarantee. Yet to obtain it, the vehicle will have to sell at least 50 percent of the more risky junior tranches, enough for the banks to be able to “derecognize” the loans. According to Rivera, an operation of public policy designed to unblock banks’ ability to lend would make no sense if the junior portions of the securitized pools were to stay on the banks’ books.

Sofferenze Clean-Up

That operation could contribute to making the transaction unattractive to Italy’s bad-loan-laden banks, analysts said.

“What the market was hoping for was a clean-up of the worst bad loans -- the sofferenze,” said Jonathan Tyce, European banking analyst at Bloomberg Intelligence. “Absent understanding how these are valued and make it into the securitizations, and with all the focus on senior tranches, it’s hard to see how this moves the dial.”

Shares and bonds of Italy’s banks have tanked this year as investor awareness has increased of the more than 360 billion euros ($390 billion) of non-performing loans clogging up their books, according to a Bloomberg News calculation based on data from the European Central Bank. 

The arrival of the ECB as a supervisor seen as less sympathetic to the banks’ problems, of toughened Europe-wide legislation designed push losses onto more investors, and the need to get banks lending again, have combined to underline the urgency of getting the soured loans off lenders’ books.

The FTSE Italia All-Share Banks Index has slumped more than 20 percent this year, reaching the lowest since October 2013 last week before rallying 3.3 percent on Friday. Dated subordinated bonds of the banks with the largest piles of non-performing debts, such as Banca Monte dei Paschi di Siena SpA, are bid at about 83 cents on the euro with yields of about 10 percent, data compiled by Bloomberg show.

Price normalized at July 31, 2012
Price normalized at July 31, 2012

The government guarantee will make it easier for investors to price the notes, and for the banks to get a price for loans they want to shift that’s higher than the rock-bottom levels offered by private-equity investors, Rivera said. Currently, potential investors are taking their cue from the valuations of bad loans on the books of four regional lenders that were resolved at the end of last year “estimated with an ad hoc model by a few officials of the European Commission,” he said.

Banks taking up the offer will have to “crystallize” losses on the bad loans, which may prompt many of them to opt for the status quo, according to Moody’s Investors Service, which estimates the value of the debt at 20 percent of par. The framework would be positive for banks’ creditors because it will reduce risk-weighted assets and leverage and potentially free up capital, Moody’s said.

The guarantee in effect makes Italy the counterparty of a buyer of the securitized bonds it’s backing. Italy is rated Baa2, two steps above junk, at Moody’s and an equivalent BBB at Standard & Poor’s. Fitch Ratings grades it a level higher at BBB+.

“Somebody somewhere has to take a loss,” said Sharon Bowles, the former chair of the Economic and Monetary Affairs Committee of the European Parliament. “Meanwhile the extra contingent liability on the Italian state may be interesting for its rating.”

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