Contagion from the 2 Friday-Night Bank Collapses in Italy?

When things get serious in the EU, laws get bent and loopholes get exploited. That is what is happening right now in Italy, where the banking crisis has reached tipping point. The ECB, together with the Italian government, have just this weekend to resolve Banca Popolare di Vicenza and Veneto Banca, two zombie banks that the ECB, on Friday night, ordered to be liquidated.

Unlike Monte dei Pachi di Siena, they will not be bailed out with public funds only. Senior bondholders and depositors will be protected. Shareholders and subordinate bondholders will lose their shirts. However, as the German daily Welt points out, subordinate bondholders at Monte dei Pachi di Siena had billions of euros at stake, much of it owned by its own retail customers who’d been sold these bonds instead of savings products such as CDs. So for political reasons, they were bailed out.

Junior bonds play a smaller role at the two Veneto-based banks. According to the Welt, the two banks combined have €1.33 billion (at face value) in junior bonds outstanding. They last traded between 1 cent and 3 cents on the euro. So worthless. Only about €100 million were sold to their own customers, not enough to cause a political ruckus in Italy. So they will be crushed.

The good assets and the liabilities, such as the deposits, will be transferred to a competing bank. According to a rescue plan apparently drawn up by investment bank Rothschild that surfaced a few days ago, Intesa Sao Paolo, Italy’s second largest bank, would get these good assets and the deposits (liabilities), for the token sum of €1, while all the toxic assets (non-performing loans) would be shuffled off to a state-owned “bad bank” – and thus, the taxpayer. According to the Italian daily Il Sole 24 Ore, the bad bank would be left holding over €20 billion of festering assets.

[Update Sunday afternoon, June 25: the Italian government decided to commit €17 billion in taxpayer funds to bail out senior bondholders and depositors. This includes a €5 billion capital injection for Intesa, which is getting the good assets and liabilities, such as deposits. The €5 billion is to protect Intesa against losses from those assets. Prohibited “state aid” under EU rules? No problem. It has now been cleared by the EU Commission.]
It is testament to just how desperate the situation has become in Italy’s banking crisis. The country’s largest lender, Unicredit, is in no position to help out: it had to raise €13 billion of new capital earlier this year just to keep itself afloat.

Whether the deal with Intesa is still possible after the ECB’s decision to liquidate the banks, and what form this deal, if any, will take, and how much the taxpayer will have to fork over, and how to sugarcoat this in the most palatable terms is what the Italian government is currently trying to hammer out in its emergency meeting.

So how did it get this far?

Italy’s government has tried just about everything to save its banks. First it set up a bad bank called Atlante, but the Luxembourg-based fund was unable to raise enough funds to make any real difference. So the government set up another one, Atlante II. That, too, ran out of money.

In the absence of anything resembling a functioning market for deteriorated credit or a bad bank with enough funds to make a real difference, Italy’s banks were unable to offload their estimated €360 billion of non-performing loans, many of them with very weak, if any remaining, collateral underpinning them. Yet on average, they are marked at around 50 cents on the euro.

In addition, Italy’s court system makes collecting on collateral very difficult, and it takes many years, as funds have found out that bought non-performing loans. Hence the refusal by market players to buy non-performing loans now.

The next partial solution to Italy’s banking problem involved trying to save its most troubled lender, Monte dei Paschi di Siena. To stave off collapse, it hired JP Morgan Chase and Italian investment bank Mediobanca to help raise €5 billion of private capital. But that didn’t work either, with investors refusing to play along having already been burnt twice in two previous capital expansions.

In December last year, JP Morgan Chase gave up on any hopes of raising new cash from the private sector. The Italian government responded by announcing it would recapitalize the banks with €20 billion of public funds. There were two problems with this plan: First, €20 billion was never going to be enough to save the banking system; second, bailing out the banks, without at least bailing in some of their creditors, was no longer allowed by EU law.

But when things get serious in the EU, laws get bent. At the beginning of June, the European Commission gave MPS a provisional green light to begin offloading €26 billion of bad loans onto the Atlante II fund. The non-performing loans would be securitized and transferred to an ad hoc vehicle at a value close to 20% of their face value. The assets would be divvied up between the Atlante rescue fund and interested private investors.

If the transaction is completed by June 28, €8.8 billion of public funds will be released to plug MPS’ gaping capital shortfall. The European Commission also agreed that all investors who had bought MPS junior bonds would be eligible for a taxpayer funded refund

But two of the private investors – hedge funds Fortress and Elliott – walked away from the negotiating table in “a dispute over the sales terms,” which likely means that even an 80% mark down on MPS’ non-performing loans may not be enough to attract private investors. If they don’t come back, Monte dei Paschi will have only one willing investor to turn to: Atlante. In other words, back to square one.

The hedge funds’ withdrawal prompted fears that it could jeopardize not only the government’s efforts to save Monte dei Paschi but also Banca Popolare di Vicenza and Veneto Banca. That has now happened. Contagion at work. And the risk of further contagion is still huge.

There are dozens of small or mid-size institutions in similar shape as Banca Popolare di Vicenza and Veneto Banca, while the problem of what to do with MPS is still not resolved. Taxpayers are already on the hook for a banking crisis that was caused by years of reckless and, in some cases, criminal mismanagement. Now the ECB’s decision to wind down two banks in an orderly manner may end up triggering the disorderly failure of others. And if that picks up momentum, all bets would be off. By Don Quijones.