The markets got the Italian Referendum wrong. It’s not that investors were surprised as evidenced by the muted reaction – it’s that investors are not seeing the slow moving train wreck that is the bailout of the Italian bank Monte Paschi. In the days since the NO vote, the private bailout led by JP Morgan has essentially disintegrated, leaving only a state bailout as the option. The market incorrectly assumes that the Italian government will simply step in and provide the EUR5B needed for recapitalization. But there are two problems with this assumption: 1.) Bailouts are illegal under EU law 2.) The amount needed for a recap is double the projection.
Since the Cyprus crisis the EU has required that states “bail-in” banks before a government guarantee – what this means in practice is that the bondholders of the bank will lose money when the Italian government steps in. But isn’t just greedy capitalist hedge funds who hold bank debt? Nope, it’s Italian citizens and depositors at the bank. If you thought there was political chaos after the NO vote, just wait until Monday morning when bank depositors find their life savings have been usurped.
The Italian government recognizes this conundrum and according to the FT, there is a plan:
“To avoid the politically unpalatable option of imposing losses on the €2bn of retail bondholders in Monte dei Paschi, a plan is being drawn up to guarantee full repayment of the first €100,000 to every junior bondholder, according to senior bankers. Senior bonds and deposits would be left unscathed. “
Besides potentially violating EU laws, the problem with this plan is it still leaves retail bondholders holding the bag – anyone with over EUR100,000 will have their money seized by the state. This will play right into the hands of the populist parties like the 5 Star Movement.
Need a Bigger Boat
The second problem with the bail-out plan is that it is too small. According to the FT:
“The bank is also likely to press ahead with plans to hive off €28bn in soured loans to a securitisation vehicle supported by a government guarantee.”
This plan sounds great until you realize that the bad loans are probably closer to EUR60b if you believe Steve Eisman of Big Short fame. In a November 19, 2016 interview with the Guardian newspaper, Eisman had this to say:
“Europe is screwed. You guys are still screwed,” says Eisman. “In the Italian system, the banks say they are worth 45-50 cents in the dollar. But the bid price is 20 cents. If they were to mark them down, they would be insolvent.”
Add this to the fact that Italian Debt to GDP is 132%…before any bailout! Given the fact that Italian government debt prices have not cratered, it is obvious that investors are betting the ECB will be the buyer of last resort. But will German citizens really want to bailout Italy?
The direct trade is to be short of Euros – the only way out is to print a whole bunch more. The second place is to look for short entries in the Italian ETF (EWI). Even if a bailout/bail-in is achieved the odds of it increasing economic growth are quite slim. And finally, where have people turned when their money is seized by the state… bitcoin.