By Lambert Strether of Corrente.

“If something cannot go on forever, it will stop.” –Herbert Stein

The consequences of former Prime Minister’s Matteo Renzi’s failed referendum roll on. Italy now has a new Prime Minister, Paolo Gentiloni, who has been asked to form a new government. Assuming he can do so, one of his first tasks will be to rescue — however this is to be done — the “struggling” Italian bank, Monte dei Paschi (MPS). On Friday, MPS’s regulator at the European Central Bank denied their request for an extra five weeks to come up with a (private) capital injection. That makes Gentiloni’s task, which seems likely to be a cobbled together public solution, urgent. If we see the central conundrum of the MPS affair as the tight coupling of financial and political risk, that coupling has, if anything, grown tighter. In this post, I’ll look briefly at Paolo Gentiloni, give some detail on the timing of upcoming political milestones in Italy, and then look at the MPS situation.

But first, a caveat on Italian politics generally. From a think piece in the Asia Times by Francesco Sisci:

[The] political balance of power in Italy [is a] a mystery coated in cryptography for foreigners and a national pastime, like football, for Italians. Moreover, in the wake of the vote, everybody is claiming a win, which is typical for Italian politics. Each enemy of recently resigned Premier Matteo Renzi, who pushed for the referendum and urged “yes” votes, all maintain that the 60% of “no” votes are theirs, and not motley pool of different opinions as they possibly are. Renzi conversely argues that the 40% who voted “yes,” which is slightly more than his party’s share of support, were on his side.

So I’m going to try to be careful not to project American political conventions onto Italy, or get out over my skis on the art of the possible, to mix clichés horribly. As ever, NC welcomes comments from readers based in Italy, or those knowledgeable on Italian politics and finance.

Paolo Gentiloni

Italy’s President, Sergio Mattarella, requested that Paolo Gentilon, as Prime Minister, form a government after consulting the forty (40) Italian political parties, and finding that a majority could not unite behind a candidate. Gentiloni is widely seen as a placeholder for Renzi, while Renzi plots his comeback:

Paolo Gentiloni, the man named Sunday as Italy’s new prime minister, is a trusted ally of his predecessor Matteo Renzi, to whom he owes his rise to the summit of national politics. Even before he was named, opponents were suggesting the silver-haired foreign minister had been hand-picked by Renzi as a stand-in leader who is dull enough not to pose any threat to the outgoing premier’s comeback hopes. Renzi, who resigned last week after a crushing referendum defeat, remains leader of his Democratic Party (PD) and has made it clear he plans to fight the next election as its candidate to head a new government.

Gentiloni[1] has little executive experience:

Born to an aristocratic family, has the title Nobile

Worked as a journalist on an environmental magazine

Elected to parliament in 2001

Communications minister from 2006-08

Appointed foreign minister in 2014

In fact:

Until a few days ago, Mr Gentiloni’s name was not even mentioned as a possible prime minister. Paradoxically, this apparent lack of prominence and ambition may have been what persuaded others to support him. After a period of high drama, Italy often picks a workmanlike, conflict-free figure as a new leader.

I’m not so sure about “conflict-free.” Or “Italy often picks….” Italy? Italy, which I take to mean the Italian electorate, rejects Renzi’s referendum, and Renzi, by a ginormous 20% margin, and then Renzi’s mini-me gets to form the successor government? Is that more than a little sketchy, or am I projecting?

Political Milestones

The first thing Gentiloni needs to do is pick his ministers and form a government. The Wall Street Journal:

After holding consultations with the other parties, Mr. Gentiloni will choose his ministers and then the new government will be sworn in. The premier and his new cabinet will then be required to win confidence votes in each of Italy’s two parliamentary chambers to fully take power. That will likely happen before this Thursday, thus allowing Mr. Gentiloni to represent Italy at a European Union summit that day.

(Here’s the agenda of that summit, which doesn’t seem to cover banking). Then comes the question of actually electing a government. Francesco Sisci:

Everybody is shouting for a new vote, although there presently is no clear electoral law.

That’s because the status of Italy’s current electoral law is in limbo. The Guardian:

Italy is awaiting a critical decision by the constitutional court on the legal status of the country’s electoral law. The ruling is expected on 24 January. Once the decision is heard, it will have major consequences on how parliamentary seats are distributed in future elections. If things go according to Renzi’s plan, Gentiloni would resign and new elections would be called once the electoral law is changed to reflect the court’s ruling. If Renzi can maintain the backing of his party, he will probably then lead the PD into the next elections.

However, it’s hard to know how or when the electoral law would be changed. Reuters:

Italy’s President Sergio Mattarella wants parliament to draft a new electoral law before any ballot is held, a source close to the president said on Tuesday, a move likely to delay any vote after Prime Minister Matteo Renzi resigns. The next parliamentary election is not scheduled until 2018 but on Tuesday there was growing consensus among party leaders for it to be held a year earlier. Interior Minister Angelino Alfano said the vote should be held in February.

So, two months out, two years out… But who’s counting? I said “milestones,” but a more appropriate metaphor might be buoys bobbing in choppy, murky waters, and drifting instead of being anchored. Not re-assuring with regard to political risk!

The Monte dei Paschi Rescue

And now we turn to the twisiting and turning of the MPS saga. Can this bank be saved? The Economist describes the original private sector rescue plan, which relied on the good graces (and who knows what else) of Qatar:

Pre-empting the [ECB stress] test results, Monte dei Paschi devised a plan with two investment banks, J.P.Morgan and Mediobanca. It would dispose of €27.7bn-worth (gross) of bad loans. The beautified bank would be injected with €5bn of equity: some from a voluntary debt-for-shares swap which has already raised €1bn; the rest from a share issue, with an “anchor” investor, likely to be Qatar’s sovereign-wealth fund, providing the bulk. In October, Monte dei Paschi also unveiled a new business plan.

Sadly, Qatar is now unlikely to assume the financial risk in view of the political risk. The Financial Times:

[B]ankers said Qatar was not interested in investing until it received clarity on the formation of a new government, which may not be in place before January.

And as we’ve seen, an elected (that is, a fully legitimate) government is months or years away. So I think I we can cross private investment off the list of options. The Wall Street Journal:

There is a chance, although it is vanishingly small , that a new government is formed over the weekend that looks stable enough for large investors, including Qatari and U.S. funds, to commit to backing an MPS share sale. That would allow the bank to launch a wider public sale and see if it can meet its target.

The political risk was bad before the referendum, and after the referendum it got much worse. Hence Italy’s request to MPS’s regulator for more time to put the deal together, a request that was denied on Friday. The Financial Times:

MPS asked the ECB’s supervisory arm for an extra five weeks to pull off a last-ditch €5bn equity injection for the lender, which emerged as the weakest in the European bank health check this summer and had already burnt through €8bn in equity in the past four years. The board of the Single Supervisory Mechanism, the ECB unit charged with banking regulation, made the decision to reject MPS’s request at a meeting on Friday, the people said.

The ECB seems to have decided that since they were going to pull the plug anyhow, they might as well not wait. The Wall Street Journal:

The answer was no. This is most likely because European regulators worried that if they granted one extension from the Dec. 31 deadline, there was no guarantee that they wouldn’t be asked for another and another, all while allowing the problems of more Italian banks than just MPS to fester.

With no capital injection from private sources, and the ECB unwilling to grant a delay, the only option left is intervention by the Italian government (assuming that one such exists). Ambrose Evans-Pritchard[2] explains “precautionary recapitalisation” in The Telegraph:

Analysts said it was extraordinary that the ECB had ignored pleas for a delay given that Italy has been chaos since the collapse of Matteo Renzi’s government, and that it should have dropped its bombshell during trading hours. “The decision is very strange. They are giving the impression that they want blood on the floor, perhaps by forcing a resolution of the bank to set a precedent,” Lorenzo Codogno, ex-chief economist of the Italian treasury and now at LC Macro Advisors. “There is a risk that there could be panic and a chain-reaction if investors start asking who is going to be the next victim,” he said. The treasury is expected to opt for a “precautionary recapitalisation” to meet the €5bn target set by EU regulators, but this amounts to state aid. It requires a “bail-in” of bondholders and depositors over €100,000.

“Precautionary recapitalisation” is as easy as it sounds. First, the process will be undertaken for the first time with MPS. A great time to work out the bugs! The Wall Street Journal:

A new European system to deal with failing banks was launched at the start of the year. So far it remains untested. Monte dei Paschi, Italy’s third-largest bank which needs to raise €5 billion ($5.37 billion) of equity, could prove a baptism of fire for the new setup.

Second, it’s a political horrorshow, because bondholders will take a haircut — and many of those bondholders are small investors:

A large chunk of the junior debt that would be written off is held by local Italian households. Monte dei Paschi sold around €2.1 billion of junior debt to its customers as savings products. Leaving them out of pocket is seen as politically unacceptable. EU rules say that 8% of all liabilities need to be wiped out before taxpayer money is injected. That is a lot of lost savings.

(“Savings products.” I love it. They call it an investment vehicle because it’s designed to drive off with your money.) So political risk only intensifies, because although I’ve urged that the referendum result was not a populist revolt, bailing in Italian households is a fine way to create one. (In a previous, smaller bail-in, at least one investor took his own life.)

Now, there may be ways to game the EU rules to mitigate the bail-ins:

Avoiding wiping out junior bondholders requires another leap and obscure EU rules published in 2013. These state that, in exceptional circumstances, bailed-out banks can hold back on nixing debtholders if that would jeopardize the country’s financial stability.

The Economist shares the same sunny outlook:

There may be room for manoeuvre. … Even with a precautionary recapitalisation, bondholders have to bear some of the burden. But with some nifty legal footwork they could be compensated without falling foul of state-aid rules. Many who bought bank bonds were under the false impression that they were as safe as deposits. Even so, sorting out compensation for mis-selling could be a messy affair.

(Well, that “messy affair” was a cloud moving in, wasn’t it?) Ambrose Evans-Pritchard disagrees:

There may be some flexibility for banks deemed systemic under EU rules but not much. Italy will be allowed to reimburse those savers who were coaxed into buying bank bonds without understanding the risks. But the permitted rebates are on a case-by-case basis. They are partial, means-tested, and slow.

How nice. Like HAMP!

And now enter the Germans. From today’s Australian Financial Review:

European Central Bank policymaker Jens Weidmann has said state involvement in the rescue of Italian banks can’t be ruled out, piling further pressure on the Rome government to bail out Monte dei Paschi di Siena. “The participation of the state alongside investors in a crisis solution can never be excluded,” Mr Weidmann told the Frankfurter Allgemeine Zeitung’s Sunday edition. Mr Weidmann, the hawkish president of Germany’s Bundesbank, did not mention Monte dei Paschi di Siena, Italy’s third-largest bank and the world’s oldest, by name in the newspaper interview.

And with regard to the bail-ins:

Since the 2007-09 financial crisis, the European Union has adopted rules that make state aid a last resort when it comes to helping troubled banks. Mr Weidmann justified state involvement by arguing that “investors particularly worthy of protection” had to be spared, the newspaper reported. The paper reported Mr Weidmann as saying he could imagine targeted state transfers to investors who had wanted to buy conservative financial products, but quoted him as adding: “The bail-in rules should not be softened.” In a bail-in, creditors and depositors take a loss on their holdings.

If I read this correctly — my interpretation is suspiciously unhawkish — Weidmann is urging that the junior bondholders have to take their haircut (“the bail-in rules”), but that the state can compensate them for it (“targeted state transfers”). If so, the sunny optimists might be right. At least for now, and assuming the targeted state transfers aren’t a HAMP-like horrorshow.

Conclusion

MPS is just the tip of the landfill. Italy has rather a lot of bad banks with rather a lot of bad debt. Japan Times:

Non-performing loans on their books amount to a combined €360 billion, roughly a third of the eurozone’s total bad debt .

Even if you only consider the capital injections Italian banks need to stagger onward, it’s still rather a lot. Financial Times:

What could trigger a crisis? The sorry state of Italy’s banks. A few urgently need an injection of fresh capital: at least €5bn in the case of Monte dei Paschi di Siena, considerably more in the case of UniCredit. Estimates of the total amount of capital needed to secure all banks approach €40bn, 2.5 per cent of gross domestic product .

With no growth, how can Italy do anything but kick the can down the road? A flatlined economy is the ultimate tight coupling of political and financial risk.

NOTES

[1] As an example of the difficulties of writing about Italian politics, we have these two seemingly diametrically opposed “facts.” Guardian:

[Gentiloni] served as the chief broadcasting watchdog during the second term of conservative prime minister and media mogul Silvio Berlusconi. In that role, he frequently clashed with Berlusconi and criticised the conservative premier’s grip on Italy’s major broadcasters. He also helped defeat legislation that would have expanded Berlusconi’s control of Italian media.

Wall Street Journal:

On the other hand: [Mr. Gentiloni] has a good relationship with former Premier Silvio Berlusconi as a result of Mr. Gentiloni’s stint as communications minister in the mid-2000s

[2] Pritchard also writes: “Italy is to nationalise Banca Monte dei Paschi di Siena as soon as this weekend, wiping out investors in a dramatic escalation of the country’s banking woes and political crisis.” There’s some wiggle room in “as soon as.” I haven’t seen it yet.