By George Friedman
The European Commission and Italy have agreed on a plan for Italy’s government to use state guarantees to help banks offload bad debt. The idea is that non-performing loans (NPLs) could be moved off the balance sheets of Italian banks onto the balance sheets of entities created by the Italian government. Banks would be able to sell the bad debt by bundling it into securities and buying state guarantees at a market price for the least risky tranches. Italy would then be permitted to sell the highest-ranked bad debt to the market. This assumes that anyone knows which of the bad debts are likely to be paid off and that private investors will pay more than a small fraction of the face value for the debt. Importantly, the European Commission is breaking all precedent by addressing an issue before it becomes a disaster. But it is also maintaining its tradition of ignoring the fundamental problem. As with Greece, it is not the agreements that are made that matter. It is the agreements that are not made that will intensify this crisis.
The fundamental problem centers on the fact that 17 percent of Italy’s loans are non-performing, which means they are not being properly paid. The definition of non-performing varies widely. It could mean a loan payment is 60 days late or 180 days late. These could be small loans or large ones. They could be collateralized loans or loans without recourse. There are theories, but no certainty, about the composition of the loans. However, there is evidence that these are mostly business loans, which means they are large ones and banks don’t classify them as non-performing until the last possible moment. Non-performing loans impact balance sheets, which in turn affect the bank’s asset base and its market value. Banks want very much to be repaid for loans, but if they are troubled loans, the banks want to delay reporting them as long as possible.
The result, as with the subprime crisis in the United States, is that banks either don’t know or don’t want to know the precise status of the loans in their portfolio. In addition, while the loans may be borrowed against collateralized assets, the banks likely have no idea of the current value of those assets. Assume that the loan is to a company in the oil drilling business. The value placed on the collateral at the time the loan was made and the value that could be realized in the event of default are most likely not connected to each other. The global financial system, and the European system in particular, are undergoing massive shifts, and the neat idea of selling off the least risky loans to private investors assumes that they can be readily recognized. While credit ratings firms will evaluate the debt tranches based on cash flow, depending on the extent of the deal’s full implementation, there could still be questions left unanswered about the status of much of the bad debts.
Until this point the European Commission’s policy was not to intervene. Its strategy was to allow Italian banks to flounder and it forbade the Italian government from trying to manage the problem. But it has now dawned on the European Commission that the Italian banking problem is real, and that it is not only an Italian problem. Italy is the eighth largest economy in the world, and its GDP is about 11 percent of the EU’s collective GDP. An NPL rate reported by the number of loans could easily balloon to a higher number when measured as the amount at risk. For the eighth largest economy in the world to have a serious banking crisis means that Europe, if not the world, certainly has a problem. Italian assets were purchased by many European banks and other institutions as quality paper. If Italy has a massive banking crisis, without any government intervention, more than Italian banks are going to fail. Why did it take the European Commission months to understand that an intervention by the Italian government is essential to the banking system? And why does the Commission regard this measure as sufficient or even meaningful in any way?
By off-loading non-performing loans, Italy’s banks may have clean balance sheets, but those balance sheets will also be much smaller. Banks will be unable to maintain lines of credit or make loans to consumers and businesses at prior rates. As a result, the Italian economy will slow down, and since it is barely moving already, this will cause the economy to contract.
The new entities created by the Italian government have a dual purpose: to clean up the balance sheets and to serve as collection agencies. Given that any investors who buy up the best of this paper are doing so only because they believe they can collect on the debt, they will take aggressive measures against tottering businesses. This might seem like a good idea to an EU bureaucrat, but this will cripple the fourth largest economy in Europe, and unlike Greece’s economic problems, this will spread to other countries.
If the banking crisis is real, and I certainly think it is, and the European Commission follows this path, it will lead to a mega-Greece. Greece is small and peripheral and can be bullied. Italy is large and central and imposing austerity will lead to economic, social and political chaos.
The European Commission must know that in the end, an Italian banking crisis will need to be solved with massive infusions of euros from the European Central Bank. The Europeans are terrified of inflation but have not noticed that infusing capital into banking systems has not had the inflationary effects economists expected. It is now almost eight years since the United States’ Troubled Asset Relief Program began and there has been no sign of inflation. But EU members talk about inflation when what they really mean is they don’t want to bear the burden of bailing out other countries’ banks.
That’s a reasonable attitude except for one thing. The Italian banks are intertwined with the Austrian, the French and the German banks. Europe’s integrated financial system means an Italian crisis is a European crisis. It is convenient to pretend that it is not Europe but an independent country, Italy, that is the problem.
The EU has a basic principle that banks live and die without government intervention. But when you have a systematic crisis, the lack of intervention means you are indirectly imposing austerity on the population as a whole. The Italians, like the Greeks, can’t simply dismiss the European Commission edicts. They can’t do what the United States did during its subprime crisis – print money. Italy doesn’t control its money supply and it can’t unilaterally monetize failing banks in order to save the situation. It can do this only by raising money from taxes, and raising taxes is the worst thing to do in an economy facing a banking crisis. But lacking the ability to print money and holding most debt in euros controlled by the European Central Bank, Italy is left with few choices.
And so the Italian banking crisis becomes a political one. All roads in this crisis lead to austerity. The reality of austerity is 45-year-old men and women losing their jobs and not being able to get others. Austerity means unemployment rates over 20 percent in southern Europe and at 50 percent among youth. It is a social catastrophe that will lead to political parties furious with governments that listen to the EU. Northern Italy is part of the European heartland, and austerity imposed on Milan or Turin will have consequences throughout the continent.