The government’s giant debt is already “vulnerable to market turbulence.”

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

For the last five months, Italy’s third largest bank, Monte dei Paschi di Siena, has been locked in talks with the Italian government, the European Commission and the ECB’s regulatory arm, the Single Supervisory Mechanism, over the design of a taxpayer-funded rescue. The negotiations have no led to a preliminary rescue deal, prompting speculation that Italy’s banking sector may finally be on the mend. But the progress has been painfully slow and as time drags on, the deep-seated problems affecting Italy’s broader banking system continue to metastasize.

Bank of Italy Governor Ignazio Visco warned on Wednesday that weaker Italian banks that will probably have to sell off large chunks of their non-performing loans could face additional write-downs of around €10 billion.

“If they were sold at the very low prices offered by the few large specialist debt collection agencies active in the market today which pursue very high returns, the amount of additional write-downs would be in the order of €10 billion,” Visco said at the central bank’s annual meeting in Rome, which was attended by his predecessor in the role, Mario Draghi. Italy’s most troubled banks, those that could be forced by regulators to write down loans, currently hold €20 billion in bad loans net of write-downs, Visco added.

But €20 billion also happens to be the amount the Italian government set aside at the beginning of this year to bail out the entire banking system – not just a few of the worst-off banks. It’s unlikely to be enough.

Spain needed to spend around €300 billion of state funds (both explicit and implicit) to steady its banking sector during the country’s financial crisis. Even after that, Spanish banks are not out of the woods, as exemplified by the worsening trials and tribulations of Banco Popular.

As with Spain, once the bailout of Italy’s banks begins in earnest, the amount of public money needed to save the system is likely to mushroom. And in a country that already boasts the third largest public debt-to-GDP ratio on the planet and whose GDP is not forecast to return to its 2007 level until halfway through the 2020s, that could be a major problem.

As even Visco concedes, the scale of Italy’s debt reduces the State and financial intermediaries’ room to maneuver, making the Italian economy more “vulnerable to market turbulence,” particularly if the only remaining buyer of Italian debt, the ECB, begins withdrawing from the market. Italy’s five-year default probability has risen to 4.4%, almost double that of France.

An even more urgent problem is finding a way to bail out the banking system without setting off a tripwire or two. That will require “extremely prompt and decisive action, close cooperation among all those involved, and the clear definition of responsibilities and priorities,” says Visco, none of which is easy to achieve in a 19-member currency union run by a plethora of competing multiple, mutually independent authorities and institutions, both national and supranational. As Visco himself concedes, in the Eurozone “effective coordination is lacking.”

That’s putting it mildly.

This week, after five months of deliberations, Monte dei Paschi di Siena was given the green light to begin offloading €26 billion of bad loans onto the books of Atlante II fund, one of two bad bank funds created to provide support for Italy’s crumbling banking sector (the other being its predecessor, Atlante I). Both funds are operated by the opaque Luxembourg-based boutique asset management firm Quaestio Capital Management.

The non-performing loans will be securitized and transferred to an ad hoc vehicle at a value close to 20% of their face value, reports the Italian financial daily Il Sole 24 Ore. The assets will be divvied up between the Atlante rescue fund and interested private investors, who apparently include US private equity fund Fortress and Italian bad-loan manager Credito Fondiario, in which US fund Elliott has a 44% stake. Another €3.3 billion of senior debt, backed by state guarantees (GACS), will be sold on the market.

MPS has set a June 28 deadline for the talks with Quaestio. If the transaction is completed in time, €8.8 billion of public funds will be released to plug MPS’ gaping capital shortfall. Once that’s done, Italian taxpayers will own around 70% of the world’s oldest bank and a full-blown bail-in of certain bondholders will have been averted.

The European Commission also said that retail investors who were mis-sold MPS junior bonds that were designed to be bailed in if the bank fails would be eligible for a taxpayer bailout.

All of this would be in direct contravention of the EU’s own rules on bank resolution if it weren’t for the inclusion of a handy get-out clause: if a bank is not deemed by the relevant authorities to be insolvent, it can be temporarily assisted with public funds without having to bail in senior creditors or depositors while junior creditors will be refunded by the newly state-owned bank. That means EU authorities effectively get to pick which banks get saved the nice way and which don’t.

As MPS’ chief “rescuer,” JP Morgan Chase, recently warned, the latter may soon include the two mid-sized Veneto-based banks, Banca Popolare di Vicenza SpA and Veneto Banca SpA, which are also desperate to avoid a bail-in but have been instructed by the Commission to find an additional €1 billion in private capital before taxpayer money can be used to save them.

That money will not be coming from either of the Atlante funds, which have already used up 80% of their capital removing billions of euros of toxic assets from the banks’ balance sheets, to no apparent avail, leaving the two Veneto-based banks and their government helpers little choice but to go cap-in-hand to rich investors in Italy’s north-eastern region in the hope they might take pity on their plight.

“We’re looking at businessmen from the Veneto area who would benefit the most from the banks’ survival and conversely would be the most damaged by their failure,” said Italy’s Finance Undersecretary Pier Paolo Baretta. This strongly worded appeal – some might interpret as a shakedown – is a powerful reminder of just how desperate the situation has become in the Eurozone’s third largest economy. By Don Quijones.

And still, years after the bailout of the Spanish financial systems, there’s Banco Popular, trying to find a savior. But that savior says the bank “itself cannot at this point make a rough calculation” of what its value is, “and if they can’t, neither can we.” Read… Banco Popular’s Co-Co Bonds Plunge as Balance Sheet Chaos Revealed in Potential Forced Sale

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