A decree implementing the Italian government’s controversial scheme to help banks shed their €300 billion stockpile of non-performing loans (NPL) has been postponed, leaving the market to speculate over how the fine print will address state aid concerns and entice investors.
Since the European Commission approved the plan in late January, official information has been limited to two communications by Italy’s finance ministry, and a conference call between its economics minister and investors.
Based on the principles revealed to-date, banks will be able to assign their NPLs to a securitisation vehicle which issues junior, mezzanine and senior notes – with the government guaranteeing the latter for a market-based fee.
Early criticism has focussed on that payment, which will be based on a basket of credit default swaps (CDS) that correspond to the issuer and maturity of the notes. But this is misplaced.
“Based on the little that is known at the moment, there should be an almost automatic reference in terms of linking the fee to CDS, so I don’t see much room to manoeuvre there. But where there is more potential for discrepancy is how you define the senior tranche,” said Bruno Cova, partner at Paul Hastings in Milan.
Where there is more potential for discrepancy is how you define the senior tranche
The finance ministry has stated that the senior tranche must receive an investment grade rating by an independent credit rating agency (CRA). As such, much depends on the CRAs’ accuracy in determining which debtors will repay an unsecured loan, which is no mean feat.
“Determining whether the senior notes represent 20%, 30% or 50% of the nominal value of the loan involves very subjective judgements,” said Cova. “The rating agencies will have to take the ability of the borrower to repay into account and that’s not an exact science; as we’ve occasionally seen – including in the sub-prime crisis – they can make mistakes.”
The CRA involvement is designed to avoid the discretionary element, but given the continuing push to reduce investor-reliance on the agencies, Cova believes more could be needed to shore-up the process.
“Besides this independent rating there should be some additional screening,” he said.
- Italy was scheduled to legislate for its NPL guarantee scheme (agreed with the European Commission late January) last Friday, but it has been pushed back to this week or possibly later;
- It was been criticised for possibly amounting to state aid, but while most of this is aimed at the CDS-rate fee to be paid by the originator, the bigger risk relates to defining the senior tranche that benefits from the guarantee;
- Credit rating agencies must identify this tranche, which is difficult for unsecured loans;
- The decree must also clarify how the guarantee can be enforced, including for the benefit of junior and mezzanine noteholders.
Italy’s government was scheduled to legislate on the garanzia cartolarizzazione sofferenze (GACs) scheme last Friday. This has been pushed back to Wednesday February 10, but sources believe it could be delayed further.
Aside from the fee and identifying the senior tranches, there are big questions surrounding other aspects of the GACs decree.
Giuseppe De Simone, partner at Gianni Origoni Grippo Cappelli & Partners in Rome said it’s critical to clarify what happens when an investor enforces against the government.
“What will be the role of the state? How will the state recover its credit deriving from its rights of subrogation after the enforcement of the guarantee?” he asked.
Given the senior tranche will be guaranteed by a public authority, they may come with certain privileges over-and-above those granted to other creditors. Investors will want to know this before buying mezzanine and junior notes issued by the GACs vehicle.
“The decree should clarify the discount rate applicable to the nominal value of the NPLs or the criteria for determining such discount rate, and the criteria for the issuance of the senior, mezzanine and junior notes,” said De Simone. “We believe that these are crucial elements for any evaluation and analysis by the investors.”
The decree must also set out whether there will be a single GACs vehicle, into which all participating banks assign their NPLs, or whether each bank will set up their own SPV.
It’s possible that rather than a single decree setting out a finalised framework, the government could take a piecemeal approach, requiring further rules and guidelines before the framework is implemented.
According to a note by rating agency DBRS, the finance ministry’s January 29 conference call suggested the guarantees would begin to be underwritten in Q2 2016. But DBRS believes the second half of the year is more likely, given it will take time for equity buyers to conduct due diligence, for the securitisations to be structured and the bonds rated.
No silver bullet
The drop in bank equity and bond prices in the days following the announcement reveal that investors hoped for something more dramatic – possibly a bad bank like those set up by Spain and Ireland.
But GACs is undoubtedly a positive development for Italy, and will help the government’s push for consolidation of bank sector.
“In my view it will facilitate these mergers, but it is not as strong an instrument as what the markets would have hoped for. It still leaves room for uncertainty as to the ability of Italian banks to quickly cure their NPLs and address concerns about their accounting treatment,” said Cova.
The scheme appears to be open to all banks, but their interest will depend on the size of the fee and their alternatives.
“The bigger Italian banks might not have much appetite to apply for this,” said De Simone. “They already have a lot of interest from foreign investors regarding their NPLs, so why would they pay for it?”
In a January 29 note, Tilo Höpker, senior credit analyst at Unicredit stated: “For anyone who assumed that the guarantees would be a “free lunch”, [it’s] evident that the guarantees will come at a cost that will impact the P&L of Italian banks taking part in the scheme.’
‘Hence, we believe that Italian banks will give prudent consideration to exactly how and what they will transfer over what time period.’ He continued.
In addition, the likes of Unicredit and Intesa have an arrangement with KKR that helps remove stressed loans from their balance sheets.
Commentators have suggested that participating banks may start with their oldest NPLs, as the insolvency of the borrower – and therefore recovery – is theoretically closer.
Speaking at an event in Turin on January 30, Italy’s central bank governor said the scheme “marks an important step toward the creation of a secondary market for non-performing loans, ending the uncertainty of the past few month.”
Acknowledging the “mixed market reaction” to the scheme, he expects “a detailed analysis of its terms and effects will improve its reception.”
Indeed, until the framework is implemented and has a track record, it’s difficult to speculate how popular it will be among the country’s struggling lenders.
“I can’t imagine the entire €200 billion will be put through the system,” said Cova. “Banks will make use of the new tool, but whether it will be used for 10% or 90% of NPLs is not yet clear.”
Unlike Spain and Ireland, Italy’s banking sector drew no systemic, government response following the eurozone crisis and has suffered ever since.
NPL guarantees are part of a broader government push to improve the struggling sector. It follows the €3.6 billion bail-in of four small banks last November and tax, insolvency and non-bank lending reforms.
The government is also rumoured to be considering permitting securitisation vehicles to become primary lenders, which could encourage copycats of KKR’s unprecedented arrangement with Unicredit and Intesa Sanpaolo whereby the private equity firms helps offload the banks’ stressed debt.
Intesa Sanpaolo, Banca Popolare di Milano and Apollo declined, and Italy’s central bank did not respond to, IFLR’s request for comment.
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