Italian Banks Clean-up time – Running out of time

Investors biggest criticisms and concerns in looking at Europe is that its banking system has yet to be completely cleaned up. Specifically Italian banks stand out as the biggest problem in the banking sector due to their high nonperforming loan ratios. The problem has not been fixed even though over the past few years banks have received numerous equity injections which have had no effect on market capitalization. The bad boy of the sector is by far BANCA MONTE DEI PASCHI SIENA (BMPS)

Old is not always good Monte’s claim to fame is that it is the world’s oldest bank founded in 1472 to help the poor with over 2200 branches and 6 million clients it is definitely part of the Italian cultural and banking fabric.

Here is what is going on, Italian banks have lent imprudently for decades. The nonperforming loan figures for the banking system are pretty horrendous €350 billion is the estimate. Nonperforming loans can be defined in several ways typically you have NPL’s which are those where you know you will not get paid, you have unlikely to pay loans where they are likely to become nonperforming, and you have in arrears.

Politics and smoke and mirrors play a big role in what is defined as nonperforming, current aggressive analysis points to the fact that doubtful loans in many cases should be qualified as nonperforming by the Italians as they are very unlikely to ever be repaid.

The situation is that Italy has run out of time to bail out the bank. The European Central Bank has insisted that a liability management exercise, (bondholders are converted to equity) has to happen before January 1 2017. The current proposal by the Italian government gives bondholders $.80 worth of equity for every subordinate bond that they voluntarily tender.

There is no way that this will get done by year-end… there are rules about forcing retail investors that hold these bonds to convert into equity therefore the bank is currently calling each and every one of its 40,000 junior bondholders in order to get them to voluntarily tender into this debt for equity swap. Good luck with that before year-end.

January 1 the ECB will force this same debt for equity conversion onto bondholders. However they will get significantly more painful write-downs on their debt before they receive equity our estimate is $.50 minimum write down therefore less equity for each bond.

The problem is even worse as the nonperforming loan book at Monte is 28 billion, the market cap is 580 million however they also have 17 billion in loans that they qualify is unlikely to pay or in arrears so really the problem is about 45 billion.

We expect the ECB therefore to bail in all junior bondholders and more importantly to bail in senior bondholders and force them to convert some of their bonds into equity effectively destroying value at the senior part of the capital structure.

Why is this important, it is very unusual that senior debt is involved in liability management exercises at banks, and even if senior debt is converted into equity, the equity valuation for the bank is likely to be high relative to its peers causing the equity price to sell off after it has been issued in the new year.

As always please let me know your thoughts I can be reached on +442078393456 or [email protected]

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