The Contrarian

“In the investment markets, what everyone knows is usually not worth knowing.”

Could an Italian Banking Crisis Ignite an EU Crisis?

Often events deemed small can ignite very significant events. The assassination of Duke Ferdinand of Austria ignited WW I. The debt default of Thailand caused a global financial crash. The next year, the Russian debt default did the same.

Now we see the banks of Italy, perhaps eight of them, in danger of being insolvent. The EU doesn’t seem to be too eager to do a bailout at this point. However, when things get too serious, they will always change their mind. The only problem, they may be too late. Look at the Lehman failure; Washington never thought that letting Lehman fail would ignite a global crisis.

Here is an excerpt of an interesting article from an astute analyst, Wolf Richter:

Bank Bailout Balloons, Tab for Italian Banking Crisis Jumps

Over the Christmas holidays, when no one was supposed to pay attention, and the markets were closed, the bailout costs of Monte dei Paschi di Siena, the third largest bank in Italy, and the center of the Italian banking crisis, suddenly jumped by 75% from €5 billion to €8.8 billion ($9.2 billion)!

Just how immense the black hole inside of a bank really is remains unknown until the bank collapses entirely and the pieces are sorted out. No one wants to know, especially not bank regulators. But when banks are teetering, and a bank bailout, or rather a bondholder bailout is being discussed, the aspects of that hole begin to emerge, and the hole keeps getting bigger the longer someone looks at it.

Earlier this year, the ECB’s stress tests of 51 large European banks determined that Monte dei Paschi was the shakiest among them. The ECB gave the bank until the end of 2016 to raise enough capital or contemplate the prospect of being wound down.

Last week, after Monte dei Paschi failed to work out a private-sector rescue deal led by JP Morgan, a taxpayer bailout was moved to the front burner. The bank’s shares and bonds were suspended from trading until the details of the bailout would emerge. This came after two prior capital increases from the private sector in recent years had failed to fill the holes. Each time, gullible investors had gotten crushed.

On Friday, the Italian government decided to shanghai its taxpayers into bailing out the bank’s bondholders with only a small haircut for holders of certain junior bonds. The decree it approved to that effect was based on the assumption that a €5-billion bailout – a “precautionary recapitalization” – would be needed.

A “precautionary recapitalization” is EU lingo for a taxpayer bailout of a bank that is “illiquid” but is still deemed “solvent.” If a bank is no longer “solvent,” it needs to be wound down, under the new EU regulations banning state aid. This would entail much bigger losses for bondholders and possibly some losses for uninsured depositors.

However, a “precautionary recapitalization” would only require that certain junior bondholders take a small first loss before a big capital contribution by the state would bail out the rest, on terms that need to be endorsed by EU state-aid officials in Brussels.

But the tab keeps ballooning.

The ECB said that the bank was “solvent” – because no one wants to even contemplate winding down the bank and dealing with the actual black hole. But it warned of the “rapid deterioration” of its liquidity position during the three weeks through December 21, caused by large outflows of deposits – a run on the bank via electronic means, as Italians were trying to haul their savings to higher ground.

Monte dei Paschi is going to deal with the ECB’s reply this way, according to Monte dei Paschi’s statement:

“The bank has quickly started talks with the competent authorities to understand the methodologies underlying the ECB’s calculations and introduce the measures for a precautionary recapitalization….”

Also on Monday, Jens Weidmann, Bundesbank President and ECB Executive Board Member, warned of a hasty taxpayer bailout, as many questions remain unanswered.

“For the measures planned by the Italian government, the bank has to be financially healthy at its core. The money cannot be used to cover losses that are already expected.”

“These [rules on state aid for failing banks] are meant especially to protect taxpayers and put responsibility on investors. State funds are only intended as a last resort, and that is why the bar is set high.”

But bank bondholders are sacred and taxpayers are a dime a dozen, and bailouts by central banks are free since they can just “print” the money, though in the end, it all boils down to the simple fact that no bailout is free, that someone always pays for it, as long as it’s not the sacred bondholders.

This banking crisis is not an accident. The toxic loans on the books of the Italian banks are often a result of corruption, political kickbacks, fraud, and abuse.

Our conclusion: We believe that the EU will find a way to prevent something as serious as 2008. But we could be wrong. And that means you have another item to put on your “What Could Go Wrong” list for 2017.