Wednesday, 7 December 2016

Monte dei Paschi di Siena - parliamo deutschiano?

Matteo Renzi was defeated in Sunday's Italian constitutional referendum and quickly resigned as Italian prime-minister. The Italian banking sector, led by Monte dei Paschi di Sienna (MPS), became more than ever front and center of investors' and press' speculations.

One day, MPS will collapse, trigger a new Eurozone banking & financial crisis and the break-up of the Euro. The next day, it will be bailed-out by the Italian government and its shares (and bonds) are a screaming buy. This is all an excellent reflection of markets' and financial press' "action bias": be busy all the time even if it achieves nothing.

What about looking at the numbers and regulatory framework first and express opinions later, guys? Not very popular in the post-fact world in which we are now living? Let's be unpopular then:

1. According to the EU's Bank Recovery and Resolution Directive (BRRD), that entered fully into force in January 2016, national governments cannot recapitalise a bank before a bail-in of an amount equal to at least 8% of the bank's total liabilities including bank's own funds (capital) has taken place. Meaning: we're basically talking about 8% of total assets. In the case of MPS, that means a bail-in of an amount of approx. EUR 12.8bn;

2. MPS' total equity is approx. EUR 9bn; junior bonds face value amounts to approx. EUR 5bn, of which approx. EUR 3bn is held by retail investors. Bailing-in retail investors is politically untenable. The challenge then is to treat all junior bondholders equally while avoiding bailing in retail investors. And the elegant solution would be to define a bail-in free face value amount of EUR 100k per bondholder - everyone would be treated equally while MPS 40k retail junior bondholders were de-facto excluded from the bail-in. This would leave EUR 2bn of junior bonds to be bailed in. Not enough. MPS needs at least EUR 5bn of additional equity. On top of it, bailing in all shareholders and junior bondholders only amounts to EUR 11bn, almost EUR 2bn short of what is needed for a state participation in the recap efforts. What to do?

3.  The straightforward answer would be to bail in senior bondholders as well. But it's probably not a good idea many will argue: MPS senior bonds are currently trading at close to 100% of face value. Senior bondholders are not expecting to bear any losses in the MPS recap process. If a bail-in of senior bondholders did occur scared investors would drop senior bonds of other Italian (and non-italian) banks, leading to massive contagion and a collapse of the Italian financial sector. Whatever one thinks of this line of argument, the good news is that a bail-in of senior bondholders is not a pre-condition for the Italian government to participate in the recapitalisation of MPS. The reason is article 32 (4.d) of the BRRD.

According to this article "extraordinary public financial support" is allowed "in order to remedy a serious disturbance in the economy of a member state and preserve financial stability". It is the so-called precautionary recapitalisation and considered a case of state aid. In case of state aid a bail-in is still required before the Italian government can participate in MPS' recap. But the degree of burden sharing is lower: only shareholders and junior bondholders are required to participate in it (see points 15, 40 and 41 of European Commission's Banking Communication from August 2013).

Will the Italian government invoke BRRD's article 32 (4.d)? You bet it will.

What are the implications? On the one hand, MPS will survive. An Italian fully fledged banking crisis will be avoided. The Euro will not break up. On the other hand, MPS shareholders will be wiped out.

Investors buying MPS banking shares expecting a giant Christmas present from the EU/Italian authorities should think again. And MPS senior bonds currently trading at close to par, and yielding 3% to 5%, are not a prime example of an investment with a spectacularly positive asymmetric risk-return profile.

To reach all these conclusions you only need to understand what makes the EU great: a combination of German rule-based institutions with embedded Italian flexibility. Learn deutschiano and you will be just fine.

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