As part of the Portfolio Guru world tour, I've set up shop in Italy for the time being. I wrote in Friday's column of the sangfroid of the British people with regards to Brexit. And in Italy, sangue freddo is a way of life. Cold blood definitely is needed at this time of year.
The coolness of the general populace should not mask the fact that Italy has some very troubling structural issues in its banking system. These issues were highlighted around Jul. 4, as Monte dei Paschi (BMPS) shares came under a bear raid. But in the past two weeks, the world has forgotten. The major news outlets have been dominated by a series of events that just seem more and more horrific, while the financial markets are sliding up against a wall of "What, me worry?"
But that doesn't change the fact that Italy's banking system is undercapitalized, losing deposits and facing a mountain of bad debt. I wrote several columns on the troubles in Greece last summer, and this feels like deja-vu, with one major difference: Italy's economy is roughly 10x the size of Greece's. So, while it was easy to dismiss Greece's problems as those of a tiny European Union outlier, Italy is very much in the center of Europe - and not just geographically and historically.
The core problem with Italy's banking system is a startlingly high balance of non-performing loans. The Bank of Italy's figures as of May show "sofferenze," or loans that need to be written off, at almost exactly €200 million, while the figure of non-performing loans is widely quoted at €360 billion. So, Italy is running an NPL ratio percentage in the high teens, which equates to about a quarter of the country's GDP.
It is just an enormous problem, and Italy's government has created a fund, Atlante, to invest in troubled banks and try to work out non-performing loans. The fundamental problem facing the Italian regulators is that post-crisis, European Union rules call for bank rescues to be done via "bail-ins" from existing depositors (who are often shareholders of the smaller coop banks) -- and that would be politically untenable for Prime Minster Matteo Renzi and his government.
So, Italy is trying to skirt EU rules, and has brought in JP Morgan (JPM) to help raise €50 billion in capital to backstop the troubled banks. Attempts by the banks to recapitalize themselves have been poorly received -- as an example, Veneto Banca's share offer was pulled in late June after shareholders committed to just 2.2% of a proposed€1.1 billion offering -- and now JPM is tasked with finding a more broad-based solution.
The ultimate cure for any nonperforming loan is -- as we saw in the US -- an improving macro picture. But that is just not happening in Italy, especially in the domestic real estate sector. According to Italian government agency Istat, in the first quarter, Italy's house prices index fell 0.4% sequentially and 1.2% year-over-year. Until that trend changes, it's going to be extremely difficult to bring underwater loans back above the float line.
Keep an eye on Italy as the "Greece of 2016." The elements of a long, hot summer for Italian banks are all in place, and watch for bank stock contagion. The FTSE Italian Banks Index has declined 41% over the past six months, so somebody's paying attention. But in this interconnected world, let's not make the mistake of thinking local problems are truly localized.