A private sector recapitalization of Italian lender Monte dei Paschi di Siena (MPS) was announced at the 11th hour last month after the results of EBA stress tests on July 29. To the surprise of no one, the bank performed disastrously in the tests, recording a fully loaded CET1 ratio of minus 2.44% in 2018 under an adverse scenario.
The ambitious deal moves nearly €10 billion of NPLs off-balance sheet and pours another €5 billion of capital into MPS’s coffers. This should increase its CET1 to 11.4% and reduce its NPL ratio from the current eye-watering 34% to around 18%.
The recapitalization was pulled out of the bag on the day that the stress tests were revealed and was led by JPMorgan, which has a long history of working with MPS. The US bank arranged a hybrid equity raising to fund its acquisition of Antonoveneta in 2008 – a €9 billion deal that many view as the root cause of the woeful situation it finds itself in today.
MPS CEO Fabrizio Viola has made it clear that the recap is the bank’s only option. “We don’t have a plan B; this is our plan,” he said when it was announced. “This is quite worrying given the complexity of the transaction and the need for a number of external factors to fall into place for it to be successful,” analyst Eoin Mullany at Berenberg Bank points out.
Concern over the health of Italy’s banks has risen sharply since June 23 when the UK voted to leave the EU. The country’s prime minister, Matteo Renzi, is under intense pressure to achieve capital support for the sector before the country votes in its own constitutional referendum in October.
The ECB’s decision to write to MPS in early July demanding that it reduce its net NPLs from €23.5 billion to €14.6 billion over the next two years brought the situation to a head.
The bank had a strategy in place to reduce this burden that included the mooted sale of NPLs to a group of US bidders, including Cerberus and Fortress Group.
But with €340 billion of doubtful and bad loans sitting in the Italian banking system – nearly €100 billion of which are in two banks alone, MPS and UniCredit – this is a problem that is not going to be solved with a quick fire sale.
Italy is acutely sensitive to the BRRD bail-in legislation that was ushered in by the EU at the beginning of this year. This is because one third (€250 billion) of bank bonds in the country are held by retail investors. The rescue of four regional banks, Banca delle Marche, Banca Popolare dell’Etruria e del Lazio, Cassa di Risparmio della Provincia di Chieti and Cassa di Risparmio di Ferrara, last year imposed bail-in on €750 million subordinated bondholders and prompted a vicious political backlash.
With an estimated €40 billion capital hole in the banking system Renzi had hoped to use the shock vote for Brexit in the UK to claim that system-wide financial stress justified the extraordinary injection of state funds into Italy’s banks. This was, however, firmly rejected by Brussels.
“I don’t think that Brexit is a fundamental reason to change these rules. Everyone knows the banks are insolvent,” one asset manager in Milan tells Euromoney.
By late July, the EC had given Renzi fairly short shrift. “The rules say if there is risk to financial stability, then there are exceptions for burden sharing and bail-in,” Margrethe Vestager, Europe’s competition commissioner, observed at a news conference in Brussels. “The important thing is to figure out what is financial instability. So far during very serious circumstances in Spain, in Greece, in Slovenia, the exceptions were never triggered.”
The EU, in recognition of the seriousness of the problem, approved a €150 billion government guarantee liquidity-support programme as a lifeline to the banks at the end of June. But they do not need liquidity; they need capital.
Recapitalization is essential for Italy’s banks to deal with the NPLs that are at the root of this crisis. Despite private-sector appetite for Italian bad debt, the gulf between buyer and seller expectations has become unbridgeable. Many banks have provisioned for their bad debts at around 45 cents on the euro; buyers are not willing to pay much above 20 cents in many cases.
“The NPL sales market has ceased to function,” says one bad debt specialist at a dedicated NPL fund in Italy. “Banks believe they have marked NPLs to where recovery will happen in, say, four years’ time. If they are pushed to sell now, they cannot bear the loss as it will wipe out the entirety of their capital. There have been some situations in the last three months where banks have refused binding offers from private buyers as it would have simply wiped out their capital.”
The Texas ratio, a measure of bad loans as a proportion of capital reserves, illustrates the problem the banks face. A ratio of more than 100% indicates that action on capital is urgently needed. MPS has a Texas ratio of 145%. Intesa Sanpaolo has a ratio of 85%, UniCredit 95%, Banco Popolare 135% and UBI Banca 110%.
As the standoff between Renzi and the EU continued, NPL sales in Italy ground to a halt. “All the confusion about government intervention is creating the hope at the banks that they can achieve higher prices,” says the asset manager. “This makes the banks even more reluctant to sell.”
In early July, Citi analysts reckoned an outright suspension of bail-in rules was unlikely as it would represent a blow to the new EBRD regime and would be strongly opposed by Germany. They believed any intervention will be small and limited to a few banks. The need to recapitalize the banks is, however, acute. They cannot deal with their NPLs if it wipes out their capital reserves.
“Italy has never taken this thing seriously,” grumbles one investor. “They have always been saying the system was solid. It is very bad for Europe if Italy can walk away from the situation without bail-in.”
It is of critical importance for Renzi that recapitalization can be agreed for banks before they risk entering resolution. Under BRRD extraordinary public support is only allowed when a bank is failing or likely to fail, so it automatically triggers resolution. It can also only take place after 8% of capital has been bailed in. However, if a capital injection takes place outside resolution, senior debt is not bailed in.
There is, however, one way around this problem. “Where support is limited to injections necessary for capital shortfalls identified in stress tests, it may be possible [to inject state support] without breaching BRRD,” one lawyer tells Euromoney. “If public financial support is only temporary and is justified to preserve financial stability generally then this will not trigger bail-in of senior lenders to the bank.” Under Article 32 of BRRD “an injection of own funds…is permitted to remedy a serious disturbance in the economy of a member state”.
This ‘serious disturbance’ option could be justifiable as a response to the EBA stress tests. “The serious disturbance route is the most likely, and possibly the only, avenue by which to do this,” says one senior banker. Many expected this route to have been taken by MPS if the private-sector deal had not been possible.
In the event, a two-stage private-sector solution was agreed. Firstly, the €9.2 billion worth of bad loans that the ECB has demanded the bank dispose of will be moved off balance sheet into a separate special purpose vehicle.
The SPV will then securitize the loans by issuing around €6 billion senior notes, covered by the government guarantee liquidity support programme, a €1.6 billion mezzanine tranche to be taken by rescue fund Atlante and a €1.6 billion junior tranche. The loans are being sold into the securitization at around 27c on the euro.
“Given that Atlante has just over €1.75 billion of remaining funds means its purchase of the mezzanine notes from MPS will exhaust the majority of its funds,” says Berenberg’s Mullany. A second fund, Atlante II, has therefore been mooted, which could be as much as €5 billion to €6 billion in size. The suggestion that funds for this could come via Cassa Depositi e Prestiti together with private-sector funds is ambitious.
“CDP sits on €130 billion of assets but it is shadow regulated by the Bank of Italy,” points out one senior banker in Italy. “There are clear rules about the quantum of risk that it can take on – it can’t take equity positions that are disproportionate. It could maybe put €500 million in but it can’t put €1 billion in,” he insists.
After the NPLs have been moved off-balance sheet the bank will launch a capital increase to be underwritten by JPMorgan and Mediobanca together with Goldman Sachs, Santander, Citi, Credit Suisse, Deutsche Bank and BAML, who have signed pre-underwriting agreements. That deal, which will be extremely dilutive, is expected before the end of the year.
“Rights issues are very binary – either they work or they don’t,” points out the banker – a fact that was amply demonstrated by Atlante having to step in on the sales of Banca Popolare de Vicenza and Veneto Banca. “Even if the state guaranteed the entire capital increase [for MPS] there is still the chance that take up might be zero,” he reckons. “Then they would have to nationalize the bank.”
There is huge relief that this private-sector deal enables Italy to dodge the prospect of a standoff with the EU over state support for now. But it is far from a done deal. “Given the number of approvals and external factors necessary for the transaction to complete, we see no room for error,” says Mullany. “As the equity underwriting is dependent on the successful disposal of the NPLs this seems the key swing factor and the key factor to be watched,” he warns.
MPS has, astonishingly, received a waiver from the ECB on the impact of this transaction on its internal models. It has avoided breaching BRRD but any deal that relies on a securitization of NPLs for which the senior notes are government guaranteed and the mezzanine notes are sold to a state-supported rescue fund is arguably just state support by another name. It is a temporary sticking plaster that illustrates how desperately European banks need to avoid bailing-in their investors.
As one Italian NPL specialist rather ruefully observes: “It is fine if you are going to bail-in investors – but you need do it after you have cleaned up the banking system, not before.”