This week Monte Dei Paschi, the weakest Italian bank, is under renewed scrutiny because it still needs to raise money to recapitalize and get rid of 28 billion Euros in bad loans it has. The reason why I focus on this issue is because of the two risks in play. The first is the potential bondholders face losses. This is a big risk because the Italian bankers and politicians decided it was a good idea to get everyday citizens to buy Monte Dei Paschi bonds. It’s almost as if the politicians and bankers are trying to destroy the economy. I couldn’t think of such a bad idea if I tried. Any hair cut on these bonds will hurt the economy because Italians viewed this as a secure investment.
The second risk is Italy leaving the Eurozone. There are restrictions with taxpayers footing the bill for bailing out the banks without the bondholders taking losses. If the Italian government violated these rules, it could be kicked out of the EU. The restrictions are the equivalent of leaving a kid who hasn’t eaten all day at a candy store with no supervision and telling him he can’t eat anything. The banks are already undercapitalized, so allowing them to fail or nationalizing them are the only options. The laws against bailing out the banks needed to come before the bad loans were made to influence the potential moral hazard.
The situation is complicated as one would expect from a nation which has a failing banking system. The goal the politicians have is to avoid the citizen bond holders losing money and provide a capital injection without violating any of the bailout rules. I think this is the most likely scenario which means the can will get kicked down the road again. That doesn’t mean it won’t get interesting.
There are three separate issues taking place this week. The first is the convertible option for the bank’s bondholders. Retail investors have until Wednesday to decide if they want to convert their junior bonds into stocks and institutional investors have until Thursday to decide. The goal of this is to get 28 billion Euros of bad loans off the balance sheet. The situation is a house of cards, so bondholders may decide to make the switch to keep it going. 35% of the shares are being offered to retail and 65% to institutional. Existing shareholders get access to 30% of the shares for retail before it’s available to outsiders. The deal involves the exchange of 4.5 billion Euros of Tier 1 and Tier 2 securities.
