Inside Italy's circle of NPL hell

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The bad-debt crisis killing some of Italy's biggest banks looks likely to get worse before it gets any better. That has frightening implications, not just for the country, but for the rest of Europe as well. In the following features, Louise Bowman and Dominic O'Neill investigate the options left to political and financial leaders from Rome to Frankfurt, and reveal the depth of the problems they face in Italy's bad-debt heartlands.

  Circle of Hell- artwork-725
  Illustration: Robert Venables
 

FEATURES

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Inside Italy’s bad-debt heartlands




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Italy: Too big to bail







 BPM-small. Italy: ECB’s first merger brings more worry



Introduction:
Europe haunted by Italy’s bank crisis

A private-sector solution to Italian banks’ bad-debt problems could be impossible to find. What would that mean for the European Union’s recently constructed pan-regional resolution regime?

By Louise Bowman

Italy stands at a crossroads: the direction it chooses to take will have a profound impact, not just on its own banks, but potentially the entire construct of European banking-sector resolution. Make the wrong choice and the spillover from a new Mediterranean banking crisis could make Greece’s problems of five years ago look almost irrelevant; and it could lead to a full-blown political, as well as financial, crisis in the EU.

"The market can easily allow the banking sector to go on for a couple of years but the problem is the 11% of performing loans that are sub-standard ['incagli’ loans]," insists Gennaro Pucci, chief investment officer at PVE Capital in London. "The problems will keep mounting and mounting. Doing nothing to fix this is the worst possible solution. If they can find a way to kick the can down the road, they will."

Could Italy simply bail out its banks and be damned? 

Some believe that the situation in Italy is so severe that this is the tipping point when pressure for state aid is such that EU rules could simply be ignored. 

"Look at the consequences of ignoring state-aid rules: in situations of emergency there is not much of a stick that the EU can deploy," reckons Etay Katz, partner at Allen & Overy. "The sanctions are not strong. The alternative is a calamity: multiple resolution of multiple institutions and potentially a sovereign crisis."

The extent of the problems facing Italy’s banks is examined in-depth in features in the following features (see right). ' Inside Italy’s bad-debt heartlands’ goes to the cause of Italian banks’ problems, the companies they have lent to, and asks if the problems might be worse than public figures show; ' Too big to bail’ looks at how mounting NPLs have led Italian banks into a capital crisis, one which the ECB may be exacerbating; and ' ECB’s first merger brings more worry’ questions whether or not consolidation is the answer for the country’s banking sector.

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Italy’s government, led by prime minister Matteo Renzi, faces two realistic paths: it can attempt to recapitalize its banking system in compliance with the Bank Recovery and Resolution Directive by securitizing its bad-debt mountain and raising capital through rights issues and/or bailing in investors. Alternatively, it can focus on finding a way round the rules that will allow funding to be funnelled into its banks while being acceptable to Brussels. A third, or nuclear, option is simply to ignore EU rules.

So far, it is going with option one. Aside from the already announced restructuring of Monte dei Paschi di Siena, this strategy will trigger the splitting of banks up and down the country into good and bad institutions, with the assets of the latter being hived off into securitization special purpose vehicles. 

As the senior notes issued by these bad bank SPVs will carry the guarantee of the Italian sovereign, they will be eligible collateral for the European Central Bank. This is where the structuring gymnastics of the scheme enter the realms of the surreal: under pressure from the ECB, the Italian banks securitize their NPLs, and the senior notes of those transactions could end up in the hands of… the ECB. 

"Investors buying the senior tranches of securitizations can repo the bonds with the ECB as they will carry the guarantee of the Italian government," confirms Pucci. 

When Euromoney asks if this is effectively state aid, he does not hesitate: "Absolutely."

This does not get around the problem of finding subordinated and junior investors, given the finite resources of the Atlante rescue fund, however. Many of the distressed debt buyers that have been focusing on NPL portfolios will now turn their attention to acquiring equity in the good banks instead. 

We are not in a bail-in scenario. The EU either has to relax its principles or go after innocent retail investors who bought these bonds bona fide 

 - Michael Immordino, White & Case

The extent of losses at the bad banks raises the thorny issue of bail-in and what this means in Italy, where one third of bank bonds are in the hands of retail investors.

"We are not in a bail-in scenario," insists Michael Immordino, partner at White & Case in London. While pointing out that the general principles of BRRD are right, he summarises a stark choice: "The EU either has to relax its principles or go after innocent retail investors who bought these bonds bona fide." 

Bailing in institutional investors ahead of retail investors is an attractive solution for governments anxious to avoid a political backlash, and it is allowed under the EU’s BRRD. 

"BRRD gives scope to discriminate between investors in extreme circumstances," Katz explains. "If there are very good reasons to create discrimination on a justified basis between institutional and retail investors, this is possible. It will not have affected the insolvency hierarchy." 

However, in Italy’s case there are simply so many retail bondholders that bailing in the institutions first may not even be enough to cushion the blow.