Italian Banks Flirt With Disaster Again as Renzi Teeters

  • Markets have priced in impact of a ‘No’ vote in referendum
  • Tottering Monte Paschi the wild card as it begins equity sale

What's at Stake in Italy's Referendum?

They’re burdened with a mountain of bad loans. Their stocks have cratered. And they have to operate in an economy prone to recession and political upheaval.

Signs have been mounting for months that Italy’s weakest lenders, and in particular Banca Monte dei Paschi di Siena SpA, were sliding toward the precipice, threatening to reignite a broader crisis. 

But don’t be surprised if Italy’s troubled banks sidestep disaster yet again.

The next chapter could start Sunday, when polls conducted before a pre-election blackout suggest Italian voters will reject a constitutional change to streamline the legislative process, a decision that could lead Prime Minister Matteo Renzi to resign. Should he quit, Italy may enter a period of political and market turmoil just as its fragile banks are struggling to win back the confidence of investors and regulators. Monte Paschi is in the middle of a 5 billion-euro ($5.3 billion) capital raising, while UniCredit SpA, Italy’s biggest lender, is considering its own stock offering.

Crises have become routine in a nation that’s been ruled by more than 60 governments since World War II. While Britain’s decision to quit the European Union and the election of Donald Trump as the next U.S. president shattered expectations, investors have been girding for Italians to thumb their noses at their own establishment for some time. Shares in the nation’s top 12 banks have tumbled about 8 percent on average in the last three months, compared with a 6 percent jump in the Euro Stoxx Banks Index.

“A ‘no’ vote is widely expected and priced in by markets, so I expect less volatility and speculation than we saw in Brexit and the U.S. election,” said Mario Spreafico, who oversees 2 billion euros as chief investment officer at Schroders Wealth Management Italy.

No Armageddon

Italy’s markets are showing little sign of panic. The country’s 10-year bonds are on course for their best week since September, while the FTSE MIB Index of stocks has outperformed all of its developed-market peers in the period.

The nation’s political leaders, the Bank of Italy and the European Central Bank could take steps, if necessary, to keep the financial system from collapsing, including making state aid available, said Nicolas Veron, a senior fellow at Bruegel, a Brussels-based think tank. “It’s hard to see a scenario that leads to Armageddon in the Italian banking sector even if Renzi does step down,” he said.

Finance Minister Pier Carlo Padoan has held discussions with the European Commission on how the government can help Monte Paschi raise capital without breaking rules on state aid, Corriere della Sera reported Friday. Italy also asked the EU to authorize a nationalization of the bank should it become necessary, the newspaper said.

The wild card is Monte Paschi itself, an institution that’s become a byword for the troubles that have long plagued Italian finance. Undermined by derivatives deals that hid losses, the lender has received 4 billion euros in taxpayer-funded bailouts and 8 billion euros from investors since 2009. Now Italy’s third-biggest lender is back for more. More than a third of its loan book has soured and its shares have fallen 83 percent this year.

Monte Paschi is planning a share sale as early as next week, in tandem with the disposal of 27.7 billion euros in bad loans. Chief Executive Officer Marco Morelli has been criss-crossing the globe telling investors how the deal will liberate the bank and pave the way for its rebirth as a lean and responsible lender. But persuading money managers to commit good money after bad may prove tough. And the deal’s interlocking structure – offloading the bad debt will only succeed if the equity raising does, too – may be too ambitious.

On Tuesday, Chief Financial Officer Francesco Mele pressed Monte Paschi bondholders on a conference call to swap their debt for shares, said people with knowledge of the discussion. If they don’t, they could incur losses if the government has to assist the lender, Mele said. Under new EU rules, stakeholders must absorb the pain before taxpayers do in a process called a “bail-in.” A Monte Paschi official declined to comment.

Mele may have raised the specter of a state rescue to scare bondholders into making the swap. But he might not be bluffing. There is a possibility Rome will have to salvage the offering if a ‘No’ vote on Dec. 4 scares off potential investors.

Read more: Countdown at Monte Paschi as capital plan faces risks

Such an intervention could spur outrage given how much taxpayer money the bank has already received. If the Monte Paschi recapitalization gets messy, that could alarm investors in other shaky Italian banks such as Banca Carige SpA, a Genoa-based lender under pressure by the ECB to clean up its balance sheet. The hope is that the market will view Monte Paschi, which has been struggling for years to right itself, as self-contained. 

“There may be no contagion,” said Veron. “Instead, the government-assisted recapitalization might be greeted with a sigh of relief because Monte dei Paschi is finally taken care of.”

A political maelstrom in Rome could alter this narrative. Pessimists fret that a snap election and the potential victory of the populist Five Star Movement, which wants Italy to withdraw from the euro zone, would put the country’s financial system under even greater stress. Investors are already reevaluating the risk of holding Italian government bonds: The gap in yield between Italian 10-year bonds and German debt has widened to 165 basis points from 118 basis points in August.

Crisis Redux?

The shift evokes memories of the roller-coaster days in 2011 and 2012 when Italy, along with Spain, was struggling to weather the euro zone’s sovereign-debt crisis. Yields on Italian bonds breached 7 percent in November 2011, raising concern the state wouldn’t be able to roll over its debt. Commercial banks, which held a lot of sovereign bonds, felt the pinch as the cost of funding soared.

While a repeat is unlikely because of the ECB’s bond-buying program, the banks do hold more than 400 billion euros in Italian government debt. If yields spike, that would crank up the pressure on lenders. 

“That’s the worst case scenario,” said Federico Santi, an analyst at Eurasia Group. “Yields on government debt go up, the ECB doesn’t purchase enough bonds, and you have reactivation of the loop that was at the core of the sovereign-debt crisis.”

Muddling Through

Santi and other analysts say it’s more likely that if Renzi does step down a caretaker government, perhaps led by Padoan, would take charge. In that event, many of the reforms Renzi has pursued, such as streamlining the clunky bankruptcy process, may carry on. That would probably calm the credit markets.

In the end, investors eyeing the coming bank capital increases will probably concentrate more on the numbers and less on the drama unfolding in the halls of power in Rome.

“The Italian banking industry has huge problems linked to their businesses, not to the referendum,” said Francesco Confuorti, the CEO of Advantage Financial SA, a Milan-based investment firm. “The banks need more capital, cleaner balance sheets, and better management.”

If the banks muddle through this latest test and conclude all is well, they will have wasted an opportunity to make the sweeping changes their industry urgently needs, said Barrington Pitt Miller, an analyst at Janus Capital Group in Denver. That’s just not good enough, he added.

‘Utterly Frustrating’

Italian banks are straining under 360 billion euros in bad debt, the equivalent of a fifth of the country’s GDP. Pitt Miller and his colleague Iacopo Dalu calculate that a comprehensive bailout of the industry could wipe the slate clean for less than 30 billion euros, compared with the 59 billion-euro rescue of some of Spain’s banks in 2012. But the EU’s new bail-in regime would probably make such a move unpalatable by punishing small investors. So while replenishing the equity coffers at Monte Paschi and UniCredit may bring short-term stability, the cycle of crisis will probably continue to turn.

"This is a resolvable situation, but we shouldn’t expect that it will be resolved," Pitt Miller said. "That is so utterly frustrating."

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