TheChek News Flow

Italian banks are down 18% ytd (-24% up to mid last week), marking the 15th worst three weeks in their 27 years of listing. Four small banks rescued in November with a ‘semi bail-in’ caught 130,000 retail clients unprepared to digest €1.2bn losses on equity and sub-debt imposed via a low 17% GBV of €8.5bn NPLs. A case-specific reading back then became a potential reference two months later when the SSM sent questions to some banks on the governance of their NPLs, triggering the bulk of the 6p.p. ytd underperformance. Deposit outflows of €10bn since then and lack of delivery on the bad bank due precisely to the Rome vs Brussels disagreement on the value of NPLs, led an already tired market to capitulate in light of €60bn ‘bail-in-able’ bonds in retail hands and the €200bn NPLs in Italy. Draghi’s reassuring speech last week and action on NPLs now firmly in sight according to the press, suggest to us the market overreacted. We attempt and show this via our ‘fire NPLs sales scenario’.

Year to date performance implies €37bn extra LLPs, i.e. ~85% coverage, even above the level applied to the four rescued banks. Our ‘fire NPLs sales methodology’ adjusts the total €204bn RE fair value collateral down to €40bn, i.e. a 80% haircut, adding 27p.p. coverage and leaving us short of 14p.p. This suggests 73% coverage (14p.p. + current 59p.p.) to be a very prudent target, in line with the 70% figure that we infer from Cerved data based on the recovery values used by specialised investors.

The €21bn extra LLPs from our NPLs fire sales scenario rise to €27bn when accounting for the migration of doubtful loans, set at €10bn below what the market is implicitly pricing in. Our scenario reduces CET1 by 180bps, generating a €13bn shortfall versus a target of 100bps above the SREP, concentrated in UCG (€8.5bn), MPS (€3bn), and BP (€1bn). Valuations post recap suggest not only that any NPLs’ driven theoretical capital shortfall looks to be in the price, but that the market might be overshooting in the region of 12%, showing 30% upside at BPER, 25% at CREVAL, and 10-15% at UCG, UBI and BP. These are the names we would play in any short term rebound.

Alternatively, let us attribute ytd prices entirely to higher funding cost on bail-in eligible items. The result is €2.2bn 2016 pre-tax negative impact, or -9% NII. This means 16% higher funding cost on bail-in items, i.e. +32bps: +7bps on deposits >€100k from 40bps currently, +52bps on senior unsecured from 325bps, +94bps on sub from 580bps. With Equity + Sub debt at 8.3% of liabilities, and rising to 38% when adding all bail-in eligible instruments, we think the cushion to be large enough to expect funding concerns to retreat. Italian banks remain best-positioned on QE owing to their short liabilities duration: ML-T funding maturing in 2016 (and thus to be rolled over lower) is 56% of total ML-T (14% of total funding) vs 38% at EU peers (8% of total funding).

Our post-recap ‘NPLs fire sales’ scenario points to 0.8x TE and 7.5% 2016-17 RoTE, suggesting a lot of bad news is priced in, even more when considering NPLs sales would carry a mix of RWAs cut, higher RoTE from lower LLPs and funding cost, and lower CoE, which are not captured in our stress test. A credit event on the banks remains possible given China, depressed oil price and US tightening, but we think QE2 in March has the ammunition to fight it via senior banks’ bonds added to Draghi’s receipt, if needed. History says things hardly change in Italy, but when it happens it is a fast and large event. Weekend press points to this week being one of such moments: 1) the four clean rescued banks to receive bids and contribute to M&A price discovery; 2) M&A on Popolari and MPS entering its final stage; 3) the BCC reform to be unveiled in Rome; 4) a solution seems finally reached on offloading NPLs via state-guaranteed senior ABS. MPS and PMI are our M&A play, BPER, BP and Creval our bad bank play, UCG our short-term rebound play, and ISP a great entry point ahead of DPS payment.