A swift solution for bad banks

  • A day in our life as a (hypothetical) banking regulator
  • Europe has suffered enough
  • More reasons to worry
  • Holiday hours

Trouble continues to brew in Europe. As the Financial Times reports:

Monte dei Paschi di Siena is to be rescued by the Italian state using a new 20bn bailout package, as a last-gasp private sector rescue plan for the world’s oldest bank looked set to fail, forcing losses on bondholders.

The government rescue, which had long been resisted in Rome, is designed to draw a line under the slow-burn crisis in Italian banking that has alarmed investors and become the main source of concern for European financial regulators.

The woes of Italy’s banking sector have also spilled over into the political sphere, contributing to the government’s defeat in this month’s constitutional referendum.

A private 5bn recapitalisation plan led by JPMorgan collapsed on Wednesday after MPS failed to find an anchor investor, a crucial plank of the deal, said four people close to the dossier.

Ah, what would Europe be without a banking crisis? This one has been brewing for some time. Although, it was knocked off the front pages when Germany’s Deutsche Bank AG [GR:DBK] got into trouble.

But now Banca Monte dei Paschi Siena SpA [IM:BMPS] is back on the front page, and it’s troubling the markets. The thing is, it really shouldn’t be that hard. If only meddling bureaucrats, politicians, and bankers wouldn’t insist on interfering with the processes of the free market…

Markets

Overnight, the Dow Jones Industrial Average fell 32.66 points, or 0.16%.

The S&P 500 fell 5.58 points, or 0.25%.

In Europe, the Euro Stoxx 50 index lost 8.66 points, for a 0.26% fall. Meanwhile, the FTSE 100 fell 0.04%, and Germany’s DAX index rose 0.03%.

In Asian markets, Japan’s Nikkei 225 index is down 99.29 points, or 0.51%. China’s CSI 300 is down 0.33%.

In Australia, the S&P/ASX 200 is up 21.73 points, or 0.39%.

On the commodities markets, West Texas Intermediate crude oil is trading for US$52.64 per barrel. Brent crude is US$54.63 per barrel.

Gold is US$1,131.09 (AU$1,561.67) per troy ounce. Silver is US$15.92 (AU$21.99) per troy ounce.

The Aussie dollar is worth 72.42 US cents.

A day in our life as a (hypothetical) banking regulator

Really, the problems facing Italian banks shouldn’t be that hard to solve. In fact, not only are they not that hard, but they’re surprisingly simple.

So simple in fact, that your editor will lay out in intricate (actually, basic) detail how it would work, if your editor had the misfortune to be in charge of Italy’s banking system.

First, Monte dei Paschi should close its doors, and declare itself to be insolvent and bankrupt.

As a result, the share price would fall to zero. That may not be as big of a deal as it may seem. As the chart shows below, the stock price is down 99.8% since it peaked in May 2007:



chart image

Source: Bloomberg
Click to enlarge


So, step one is to eliminate the ‘owners’ of the business — the shareholders. They oversaw the bank’s operations, and made money as the share price went up. And the market should punish them for their incompetence, naivety, and hubris as the share price falls to zero.

Next, the administrators of the newly bankrupt bank should inform bond investors that the bank is unable to honour interest and principal repayments on the bonds.

That would be a default. The bonds would fall significantly. They may not fall to zero, but they would certainly collapse, as bond investors would have no certainty of recouping any of their investment.

As for the exact price to which Monte dei Paschi bonds would fall, that’s impossible to say. One thing we’re fairly certain of knowing, is that its bonds would be priced to yield more than the current 7.34%.

You can see a chart of the bank’s bond yield below. This is the yield for the 2.5% coupon bond, maturing February 2017:



chart image

Source: Bloomberg
Click to enlarge


The problem is that investors in the bonds expect to be made whole with their investment. Or if they don’t get their full principal back, the expectation is that they’ll get most of it back.

In which case, there’s no need to sell.

That creates a further problem. The artificially high price (low yield) for the bonds is a disincentive for other, perhaps better capitalised, investors to buy the bonds on the cheap.

Why would any investor do that?

That brings us to the next step of our solution for Monte dei Paschi and other Italian banks. That is, the opportunity for another bank to buy the debt in order to play a part in the recapitalisation of the bank.

Buying the bank in a distressed state should be a good speculative investment for another, better capitalised bank, or even a private equity investor.

It’s important to remember that, just because the bank is in an awful state, it’s not entirely worthless. Monte dei Paschi, like any bank, has a huge amount of assets on its books.

According to Bloomberg, at the end of 2015, it had €130 billion of loans on its books. Of that, it has reserves for bad loans of €23.3 billion.

That’s a huge reserve. However, just because the bank has set aside a reserve of that amount, it doesn’t mean the whole amount will ‘go bad’.

Arguably, the bad loans have increased as businesses have perhaps taken advantage of Monte dei Paschi’s precarious situation. Perhaps a borrower thinks they can delay or default on a loan, believing that the bank will be keen to renegotiate terms.

That may or may not be the case.

Regardless, it’s not strictly true to say that Monte dei Paschi is worthless. Instead, as we see it, it’s a potentially outstanding opportunity for a risk-hungry investor to buy a distressed bank on the cheap.

However, this plan would require further action. It would require investors to take a ‘haircut’ on their deposits. Like the shareholders and bondholders, they should be punished for daring to trust such a poorly run bank.

Savers deposited their money into the bank without a care in the world. They either ignored the bank’s problems, didn’t understand the bank’s problems, or they took the lazy view that whatever happened, the Italian government would bail them out.

Those savers should be punished. In a free market, they would lose 10%, 20%, 40%, or perhaps 50% or more of their savings on deposit. The reduction in the bank’s liability would help repair the bank’s finances and balance sheet.

[Note: It may seem odd, but on a bank’s balance sheet, money in a customer’s savings account are a liability for the bank. It’s a liability, because the bank has to repay the customer his or her deposit on demand. In contrast, a loan issued by a bank to a borrower is an asset on a bank’s balance sheet. That’s because it receives interest on that asset from the borrower.]

In order to prevent a bank run when the bank reopens its doors, the bank would institute capital controls and/or force all demand deposits to be converted into term deposits.

This would provide some stability to the bank, and allow it to attract new deposits. And if you think no new investor would deposit their savings into such a bank, think again. People have short memories!

See, it’s simple. It can all happen without the involvement of government. Without the involvement of a central bank. And without the use of taxpayer resources.

The free market is wonderful. It has a solution to every problem. All it needs is the time and space for it to be allowed to work.

If central banks around the world hadn’t intervened to bail out banks in 2008 and 2009, this is how things would have played out everywhere. Yes, it would have caused a short-term shock. But in a matter of days, it would have become clear to the market exactly what was happening, and exactly how things would pan out.

Importantly, rather than big investment firms and other banks choosing to hold cash at the central bank, or investing in pointless government bonds, that cash would have found its way to the biggest and most distressed bargain investment of all time — the world’s banks.

In short, if left to the free market, the current ongoing crisis would have ended almost before it had begun.

If you happen to be connected to bigwigs in the financial system, feel free to pass on our solution. They can have it for free. We have no use for it!

Now that we’ve finished solving the world’s banking problems, on with more interesting and important details…

Europe has suffered enough

As reported by the Wall Street Journal:

The U.S. is facing an eggnog deficit.

The punchbowl and punching-bag favorite is selling out this Christmas, with dairies reporting record sales and surprising shortfalls.

An eggnog shortage may be bad, but at least it’s not as bad as the terrible situation faced by Britons in the lead up to Christmas in 2004. As the Guardian headlined at the time, ‘Lard crisis: mince pies threatened as supplies dwindle’.

The report notes:

Lard fans regard it as a gastronomic delicacy which makes cakes, pastry and roast potatoes taste fantastic. But others, notably vegetarians, think it is disgusting animal fat…

But there is now a national shortage of lard and supermarket shelves are emptying. Notices have begun to appear apologising for the European lard shortage.

Zut alors!

A ‘European lard shortage’? Is there an affliction known to man to which Europe isn’t susceptible? Banking crisis. Debt crisis. Refugee and asylum seeker crisis. Terrorist crisis…lard crisis.

Oh, the humanity.

We can only hope such calamities bypass Europe this Christmas. Surely they’ve suffered enough already.

More reasons to worry

In yesterday’s Port Phillip Insider and today’s Money Morning, we mentioned our fondness for the ‘Dow Theory’.

If you’re not familiar with Dow Theory, check out today’s Money Morning here.

We pointed out our concerns about the Dow Jones Industrial Average remaining near its high, while the Dow Jones Transportation Average has slipped.

So, what’s the deal with the component companies of the Transportation Average? Are revenue and profits in trouble?

Well, it depends which subsector of the Transportation Average you look at. If you look at parcel delivery companies, such as FedEx Corp [NYSE:FDX], Ryder System Inc [NYSE:R], and United Parcel Service Inc [NYSE:UPS], you’d see each has increased revenue and profit for the last quarter, compared to the same quarter last year.

Good news.

However, knowing your editor’s bearishness, you’ll be well aware that wherever we giveth hope, you can be sure we’ll readily snatch it away again.

Because while parcel delivery firms appear to be on their uppers, American railroad companies are decidedly in a downer.

Norfolk Southern Corp [NYSE:NSC] has seen revenue and profit fall from US$724 mln and US$471.7 mln to US$705 mln and US$436.9 mln respectively.

Union Pacific Corp [NYSE:UNP] has seen revenue and profit fall from US$5.56 billion and US$1.29 billion to US$5.17 billion and US$1.12 billion respectively.

And Kansas City Southern [NYSE:KSU] has seen revenue and profit fall from US$631.9 mln and US$131.5 mln to US$604.5 mln and US$120.5 mln respectively.

Is it a sign of impending doom? Or is it just a cyclical soft patch?

Who can say? But we certainly have our bearish crash radar alarm at hand, and are ready to press at a moment’s notice.

Holiday hours

Again, for your useful information, a quick note on business and trading hours over the Christmas and New Year holiday.

First, the hours for Port Phillip Publishing’s Customer Service team:

Friday, 23 December – Close at 2pm

Monday, 26 December – Closed

Tuesday, 27 December – Closed

Wednesday, 28 December – 9am-5pm

Thursday, 29 December – 9am-5pm

Friday, 30 December – 9am-5pm

Monday, 2 January – Closed

Tuesday, 3 January – 9am-5pm

During this period, most editorial staff will be on leave, with close to full service resuming on 3 January.

Next, the ASX trading hours:

Friday, 23 December – Market closes at 2:10pm

Monday, 26 December – Market closed

Tuesday, 27 December – Market closed

Wednesday, 28 December – Normal market hours

Thursday, 29 December – Normal market hours

Friday, 30 December – Market closes at 2:10pm

Monday, 2 January – Market closed

Tuesday, 3 January – Normal market hours

Finally, the following is the holiday schedule for the New York Stock Exchange:

Friday, 23 December – Normal market hours

Monday, 26 December – Market closed

Tuesday, 27 December – Normal market hours

Wednesday, 28 December – Normal market hours

Thursday, 29 December – Normal market hours

Friday, 30 December – Normal market hours

Monday, 2 January – Market closed

Tuesday, 3 January – Normal market hours

We hope that helps.

Cheers,
Kris