Prevailing Gray Swans: The Clear and Present Danger List for the Week Ending December 16, 2016
2. European banking collapse (ground zero: Italian banking sector).
Deep Background and Threat Forensics: Briefing Focus
[economics | finance | politics | sociology]
The Italian banking collapse is a clear and present danger to the Eurozone and to the viability of the global economy at large for a categorically different reason than Deutsche Bank (DB) [Prevailing Gray Swan on DB] or other threatening GSIBs (“global systemically important banks) per the IMF [IMF: GSIBs risk exposures (pp. 29–31) (pdf)] like HSBC or Credit Suisse. The Italian banking sector’s threat is not about derivative exposure, it is about an organically increasing ratio of non-performing loans (NPL) relative to bank capitalization and this has now reached the point of measuring NPL to Italian GDP.
At present Italy has about €200B as formal NPL per the chart above which has expanded at a very predictable rate but when you consider the European Banking Authority (EBA) new definition of non-performing exposures (NPE) as opposed to the older definition…
The NPEs are made of:
1) bad loans or bad debts (Italian “sofferenze”) which are the defaulted loans;
2) unlikely to pay in full and in a timely manner (Italian “incagli”);
3) past-due of more than 90 days (the Italian “scaduti o sconfinanti”);
4) restructured loans (The Italian “ristrutturati”)
According to the Bank of Italy, the severe recession in Italy (with a drop of almost 10 percentage points of GDP in 2008–2014) “has caused a sharp deterioration in the quality of the loans in banks’ balance sheets.”
Between 2008–2014, the NPLs of the entire Italian banking system grew from €131 bn to €350 bn and from €75 bn to € 200 bn for bad debts alone.
So, a rough calculation of NPE-to-GDP is:
Italy GDP (2015) USD 1814.76B = €1620B
NPE-to-GDP: €350B/€1620B = 21.6%
Looking deeper, what are the hidden risks? What are the prevailing naïve assumptions versus real-world market realities? In other words, what are these NPEs worth at current market values (marked-to-market) as opposed to the terms of the loans presently on the public books at the banks?
Italy’s banks are thought to be the Continent’s weakest. There are $408 billion in past due loans sitting on Italian bank balance sheets. Investors value these loans at 20–30 cents on the dollar if they are secured, and as little as 5 cents if they are unsecured while banks have marked them at between 50–65 cents on the dollar.
The yawning gap between market pricing and that of Italy’s banks is reminiscent of how unrealistically Lehman valued its loans before going under. Unicredit, Italy’s largest bank, has seen its stock price halved this year as investors worry its capital is insufficient to handle the Brexit fallout.
Revising the number:
NPE-to-GDP: €408B/€1620B = 25.2% (!)
UniCredit, Italy’s biggest bank, has suffered particularly badly this year. It has a market capitalization of just 12 billion euros, dwarfed by its non-performing loans worth 51 billion euros. Italian banks as a whole have non-performing debts worth 198 billion euros, a total that’s been rising ever since the financial crisis. [Ed. NPL, not NPE: NPL is 425% of market cap of UniCredit and market cap has been trending downward].
(Source: Bloomberg View, Mark Gilbert, “Brexit Is a Lehman Moment for European Banks”)
Another perspective is the Texas ratio:
To calculate the Texas ratio, the book value of all nonperforming assets (including other real estate owned) is divided by equity capital plus loan-loss reserves. Only tangible equity capital should be counted in the denominator — the intangible parts, like goodwill, are excluded. In the simplest terms, the Texas ratio measures a bank’s likelihood of failure by comparing its bad assets to available capital. When this ratio exceeds 100 percent, a bank’s capital cushion is no longer adequate to absorb potential losses from troubled assets. In other words, the bank is at greater risk of going bust. And as shown in Chart 1, the Texas ratio seems to be a good early indicator of bank failures, even if it does tend to overpredict the number of problem institutions.
(Source: Federal Reserve Bank of Dallas (p. 1))
Now examining the Texas ratio of the Italian banking sector:
and vs. other prominent global banks:
By the metrics established by the Texas ratio, UniCredit is less stressed than two other Italian banks: Banca Monte dei Paschi di Siena and Unione di Banche Italiane and five other European banks: Banco Sabadell, Banca Popolare, and Banco Popular Español (Spanish banks) and Eurobank Ergasias and Alpha Bank (Greek banks). The same argument can be made for a few large Spanish banks and for Portugal in general, it is just that the situation is more systemic and pervasive in Italy. (Just for perspective, this is the Texas ratio for US banks.)
Unlike Greece and with the United Kingdom in transit out of the formal political influence of the EU or European Central Bank, Italy is the Eurozone’s third largest economy:
So when you combine the mark-to-market value, the Texas ratio, and the scale of the Italian banking sector relative to the EU aggregate, the logic for the Italian banking sector warranting Prevailing Gray Swan status is unassailable especially considering the predicament is deteriorating or — at best — in stasis due to structural reasons.
What are those structural reasons? In other words, why isn’t this problem going to ever go away?
Beginning with the IMF:
Productivity and investment growth are low; the unemployment rate remains above 11 percent, with considerably higher levels in some regions and among the youth; bank balance sheets are strained by very high NPLs and lengthy judicial processes; and public debt has edged up to close to 133 percent of GDP, a level that limits the fiscal space to respond to shocks.
Against this backdrop, the recovery is likely to be prolonged and subject to risks. Growth is projected to remain just under 1 percent this year and about 1 percent in 2017. Risks are tilted to the downside, including from financial market volatility, the refugee surge, and headwinds from the slowdown in global trade. This growth path would imply a return to pre-crisis (2007) output levels only by the mid-2020s and a widening of Italy’s income gap with the faster growing euro area average. It also implies a protracted period of balance sheet repair, and thus of vulnerability.
(Source: IMF, July 11, 2016, IMF Executive Board Concludes 2016 Article IV Consultation with Italy)
Unfortunately, the IMF failed to set the stage. A little history is required to understand the big picture. Due to a combination of globalization and its incessant labor arbitrage (think China vs. Italy) and adoption of the euro in 1999, a much stronger currency then the lira was (and the euro’s exchange rate that the Italian government cannot finesse to its liking), Italy lost its ability to remain competitive on the global stage and the NPL/NPE predicament is scoreboard of said loss of competitiveness.
Consider that globalization had already done a number on the country’s once magnificent industrial base when Italy opted into the euro and left the lire behind. Since then, the country’s industrial capacity has been further decimated, shrinking by 15 percent. To take but one example, in 2007, Italy manufactured 24 million appliances; by 2012 it had declined to 13 million.
Add up the economic consequences and you begin to understand why Italian unemployment is running north of 12 percent while putting four-in-ten young Italians are out of work.
SVIMEZ warns that the downward spiral is turning a cyclical crisis into a “permanent state of underdevelopment”. In short, southern Italy is close to social collapse, and there is precious little that premier Renzi can do about it without reclaiming Italian economic sovereignty.
This is politically explosive. Tens of thousands of Italian depositors at small regional banks have already faced the axe, learning to their horror that they had signed away their savings unknowingly. The Banca d’Italia said the EU bail-in law has become “a source of serious liquidity risk and financial instability” and should be revised before it sets off a run on the banking system.
(Source: Daily Telegraph, Ambrose Evans-Pritchard, May 11, 2016, “Italy must choose between the euro and its own economic survival”)
Bail-ins are not theory in Italy. More than 100,000 investors last year in four small Italian banks saw their investments wiped out. Some lost their life savings. This is in the foreground of the Italian mind unlike Americans who are in the same boat due to legislation passed in the US Congress without front-page press coverage.
The social dimension of this Prevailing Gray Swan looms large.
This has now escalated from the economic arena (adoption of euro, loss of competitiveness); financial arena (ballooning national aggregate NPE and Texas ratios); and social arena (companies and depositors fear losses from confiscation) to the political arena invoking several factors that have global and European significance having near and long-term consequences:
- Concrete grounds for an Italian referendum to leave the EU;
- Contagion risk with banks holding Italian debt (catastrophic network effects);
- Pre-emptive bank runs due to newly enacted bail-in laws in the Eurozone resulting in imperiled bank liquidity and potential insolvency; and
- Several large Italian banks are technically on the brink of insolvency due to mammoth NPE levels and are facing the same structural headwinds since 1999 (the euro), 2008 (global banking crisis/housing crash), and 2011 (European debt crisis).
As for immediate contagion risk in the form of counterparties in the event of Italian debt default, a disproportionate share is held by France:
The Italian banking collapse is further complicated by recent developments between Italy, Germany, and the ECB. Italian prime minister Matteo Renzi wanted to inject up to €40B without forcing losses on shareholders and creditors (i.e. no bail-in). German chancellor Angela Merkel responded, “We cannot renegotiate every two years the rules of the banking sector.” This may come back to haunt her given that Deutsche Bank is walking the plank as we speak.
After the UK’s shocking Brexit victory, Italy secured significant leverage and now occupies the catbird seat in regards to resolving its long-brewing NPE banking predicament for one simple reason: if the ECB and Berlin cannot bend the rules and offer a bail-out in lieu of a mandated, bone-crushing bail-in, then Italy will most assuredly leave the EU at the first opportunity without looking back with an attitude of good riddance. Italy’s only rational chance of survival in a light-footed, globalized world is to regain its sovereignty and control its own fate with its own currency — win, lose or draw. Otherwise Italy faces a certain fate of slow and painful death — or austerity — belly up — Greek style. In fact, a default on its debt to the hilt, both sovereign and commercial, is the most fruit-bearing strategic option going forward notwithstanding immanent short-term chaos.
As for the eurozone? If Italy were to leave, the eurozone would be kaput. Sure, Brussels and Berlin can saber-rattle to the press but after all is said and done, there will be more said than done. They know full well that after the UK and Italy, many countries would want to leave a sinking ship. And NATO, formed in 1949, is not tied at the hip with the EU. On the other hand, if Italy remains and is bailed-out — no strings attached — France, Spain and Portugal would knock on Brussels’ door with hat in hand and that would take a lot more than Draghi’s “whatever it takes” hubris can muster. He bit off more than the ECB can chew, or print. Simply, the EU cannot afford to stay together: its structure is inherently and fatally flawed in a globalized ecosystem where Darwinism rules the roost. The EU will remain viable as long as the ECB’s printing press remains viable and that is underwritten by trust because trust, shortly followed by a denial period where the can is ingeniously kicked down the road, are the only things that back any fiat currency. The long history and packed graveyard of fiat currencies, without exception, has taught us that trust will be violated sooner or later. A fiat currency’s demise is a fait accompli — it is never “different this time”.
Ergo, this endgame — however long it takes to play out — results in checkmate. The superior opponent in this chess match is globalization — the wrath of the invisible hand — but perhaps not exactly according to Adam Smith’s playbook or what the eurozone fathers were game planning in 1999. In the future, it is the euro — not the pound, lira or franc — that is the BIG short. That is why there is a separate Prevailing Gray Swan that focuses just on the economic, financial, political, sociological and military forces that will cause the immanent dissolution of the EU.
Prudent Actions to Strongly Consider
Immediate withdrawal of all assets and funds subject to a potential bail-in.
Prepared by: James Autio