Focus on Monte dei Paschi di Siena

In this continuation from the previous newsletter we enter more in depth into the merits of the Monti Bonds as well as explaining the infamous three derivatives contract recently called into question (Alexandria, Santorini and Nota Italia).

Monti Bonds

Although it could be erroneously believed that Monti Bonds have been invented in December 2012 as a solution to Monte dei Paschi di Siena’s derivative-trading losses, this is not the case. These new financial instruments have been launched by the Prime Minister Monti (laws 135/12 and 228/12) under MPS’ specific request and were aimed to strengthen the bank’s capital base. The Tuscan bank indeed failed to meet European Banking Authority’s tougher capital requirements (8 Dec. 2011) aimed to cover an excessive exposure to State bonds ( i.e. Tremonti Bonds subscribed in 2009 for €1.9bn).

Other 70 banks globally(among whom the italian Unicredit, Intesa Sanpaolo, Banco Popolare and Unione di Banche Italiane) were included within the ECB’s recommendation, but not all of them required a state bailout: while a few decided to deleverage by reducing the size of their Risk Weighted Assets , the majority opted for a capital increase. So why did MPS require the second state bailout in four years? Of course the recently declared losses on trade derivatives accelerated the whole procedure, but it is interesting to notice that a capital increase would have crashed with the interests of the already indebted Foundation, MPS’ main shareholder (34.94%). Committing the amount of capital required to adapt MPS’s core tier 1 ratio to Bruxelles’ 9% requirement by June 2012 would have been impossible for the Foundation on its own and a dilution of its quote would have undermined its hegemony.

Consequently, a state bailout turned out to be the best solution to pander to MPS’ shareholders. However, as a fundamental condition of the state bailout, the potential capital increase in the next five years has been approved, with the important condition that at least 20% goes to private investors that at the time of the issuance own less than 2% of the existing shares. We will see if it will eventually be executed.

Thus by the 1^st of March MPS will subscribe € 3.9bn of Monti Bonds (€2bn to increase capital base and €1.9bn to repay Tremonti Bonds expiring in June 2013). A second tranche of €171mln aimed to cover the interests accrued on Tremonti Bonds will follow the approval of the 2012 financial statements, where €2mln losses are expected.

The Italian Tar of Lazio has recently approved the € 3.9 bn bailout, following Bruxelles intervention. The EU indeed insisted for the interest-payment terms to be slightly modified: MPS is now allowed to use newly subscribed government bonds only to pay those interest that have accrued by 31.12.12, whereas the new coupons will need to be paid exclusively in cash and/or shares. As a consequence, the €400mln coupon that must be paid in spring 2014 augments the possibility of a nationalization in case MPS does not have enough cash and is therefore forced to issue new shares. According to Monti Bonds’ covenant, in fact, in case that the beneficiary of the state bailout declares not to hold enough liquidity to pay the 10% coupon (which will be increased by 0.5% every two years up to a maximum of 15%), he will be allowed to issue new shares that will be subscribed by the Treasury up to the amount of the interests owed. According to some analysts, this could lead the Treasury to become a relevant shareholder of MPS within one year.

Derivatives

On the derivatives contracts side, the information obtained reflect in part the lack of disclosure and cooperation that the Tuscan bank has been having with respect to some transactions, in particular Nota Italia for which hopefully more details will emerge.

Alexandria Investments LP
Size: € 400 mln CDOs. € 3 bn BTps.
Counterparty: Nomura.
Year: 2009.
Alexandria is a secret operation that the top management of MPS created with Nomura to hide a €220mln loss generated from the bank’s investment on CDO squared products. Thanks to the agreement with Nomura, MPS exited the CDO investment and purchased better quality securities. At the same time Nomura provided MPS with funds to purchase €3bn of 30-year BTps. These government bonds were then the object of an interest rate swap in which MPS was giving the fixed rate to the Japanese bank in exchange for a floating rate linked to the spread on Euribor.
On the one side losses on CDOs do not appear in financial statements, but on the other side MPS accepted to keep a huge size of non-interest-producing 30-year government bonds on its balance sheet.

Santorini Investments LP
Size: € 1.5 bn.
Counterparty: Deutsche Bank.
Year of inception: 2002, restructured: 2008, liquidated: June 2009.
Back in 2002 MPS decided to enter into an equity swap transaction with Deutsche Bank to reduce the underlying volatility on its 3% Sanpaolo IMI equity stake. When in 2008 as a consequence of the financial crisis the derivative recorded a €367mln loss, MPS decided to restructure the agreement with DB to avoid recording the loss in its books. The new contract implied that the Italian bank would sell off the loss-making derivative and it would also purchase €1.5 bn of 30-year BTp from the German bank itself. The cash that MPS needed to buy the government bonds was provided by entering a repurchase agreement on the same BTps with DB. The two banks then created an interest rate swap similar to the one of Alexandria. This way losses were “shifted” from the equity swap to the BTps. A loss on government bonds is more “appropriate” for a commercial bank like MPS than one on an opaque and complex financial instrument, with the additional upside that it would not appear on the Income Statement thanks to repo agreement.

Hence, MPS has € 25 bn invested in Italian Government Bonds, and in particular long term bonds (i.e. BTPs), that with an average annual coupon of 4.2% would produce more than € 1 bn in interest rates every year. However, it receives only the Euribor rate on a consistent portion of them (€4.5bn).

Nota Italia
Size: undisclosed (it is known only that its fair value has been restated to a loss of €151.7mln)
Counterparty: JP Morgan.
Year: 2006.
Monte dei Paschi di Siena agreed with J.P.Morgan on the sale of credit default swaps (CDS) on Italian government bonds in 2006, without giving any information to the bank’s board. At that time the price of these instruments was between 19 and 26 basis points. The issue of this transaction lies in the fact that the default of a Sovereign Institution directly affects the solvency of any domestic financial institution. Hence, JPM decided to create the derivative named “Nota Italia” instead of buying directly the CDSs from MPS. Nota Italia was a complex instrument through which the Italian bank indirectly sold CDSs on Italy to JPM, and at the same time JPM was sure of receiving the payment in case of a combined default since the pledged collaterals were AAA securities.
MPS started losing money on the operation when the spread between the BTp and the Bund soared, and it has been recently restructured with the elimination of the derivative component linked to Italy’s sovereign risk.