CRG Banca Carige SpA

By Manuela Mesco and Giovanni Legorano 

MILAN--The Italian government outlined Wednesday the details of the deal it struck with the European Commission to help Italian banks manage their large portfolios of bad loans, but doubts about its effectiveness pushed shares in some Italian lends sharply lower.

Under the agreement, the Italian government will provide guarantees based on credit default swap prices on Italian bonds that are considered as risky as the bad loans themselves.

The government will help banks to bundle bad loans into bonds, thus securitizing them, by selling guarantees to banks that will make some tranches of bad loans less risky.

But analysts warned that the plan--which is a much lighter version than the bad banks used by countries like Spain to deal with bad loans during the financial crisis--will only partially relieve the problem.

"There are definitely advantages for banks," said Fabrizio Spagna, managing director at Axia Financial Research. "But it is far from being the panacea for the bad loans."

The details of the plan come after the European Commission and the Italian government reached an agreement late Tuesday after months of protracted negotiations on a plan for Rome to help Italian banks lighten their load of nonperforming loans.

The economy ministry said the guarantees will make it easier for banks to finance deals and shed some of their bad loans. Italy will guarantee only the safest loans, and banks can request a guarantee by paying a fee to the government.

The price of the guarantee will be calculated by considering credit default swap prices of banks that carry a risk level equal to that of the loans guaranteed. The price rises with the duration of the notes. The government will provide a guarantee only if the notes have a rating of investment grade or higher

The price of the guarantees was the most contentious part of the negotiations, as the European Commission wanted to ensure they were priced at market terms, so that they didn't violate the bloc's state aid rules. Were the price of the guarantee to be lower than what the market charges to insure comparable risk, then it would have been constituted as state aid.

The Italian government has been eager to find a solution to a problem that weighs heavily on Italian banks and the economy at large, which has shrunk 10% since 2009, a deep contraction that has hit local lenders hard. Years of poor management at the banks have combined with Italy's poor economic performance to push the level of bad loans higher.

Italian banks' gross bad loans, measured at their face value, stood at EUR201 billion ($217 billion) in November, 11% higher than the year-earlier period, according to the Italian banking association, ABI. This amount considers only the worst quality of bad loans, where the debtor is considered insolvent.

Gross bad loans were 10.4% of total loans in November, according to ABI, the highest percentage figure since 1996.

Concerns about the bad loans have soared recently, helping to send Italian stocks tumbling. An index of Italian banks has slumped nearly 25% since the start of the year, although it partly rebounded this week in anticipation of a deal with the commission on the bad loans.

After some initial gains, most Italian banking stocks turned into negative territory, with some of them accumulating large losses. Traders said the remaining uncertainty about the implementation of the scheme, in particular, whether banks would suffer losses when they off-loaded their bad loans, was still weighing on the sector. Banca Monte dei Paschi di Siena, considered the most in need of a solution for its bad loans, was the main gainer Wednesday, with shares trading up 3%. Italy's FTSE MIB was down 1.4%.

Analysts say the impact of the mechanism will vary widely across Italian banks, but is unlikely to eradicate the problem. Analysts at Citibank noted that the Italian solution is very different from those set up by other EU member states such as Spain and Ireland, where banks were forced to sell part or all of their bad loans at a set price to a government-backed bad bank.

"The Italian scheme is a much lighter version and as such it is likely to have a more muted impact on banks' balance sheets," Citi's analysts wrote in a note Wednesday.

The government guarantee will cover the gap between the price banks are willing to accept and the price buyers are willing to pay. As a result, the mechanism's success at relieving the banks of bad loans depends on how much of the price gap the state guarantee will help reduce. Italy's treasury ministry didn't release those details.

Moreover, the guarantee only backs the better-quality portion--or the senior tranche--of the bad loans portfolio. Analysts expect that the worse-quality tranches will remain largely unsold.

Using the mechanism could also force the banks to make sizable write-downs. For instance, analysts at Barclays estimate that, even with the guarantees provided by the state, the six large banks would realize losses of EUR6 billion to EUR28 billion if they accessed the mechanism. Banco Popolare SC and Banca Monte dei Paschi di Siena SpA are seen as the two most vulnerable banks under this scenario, while Intesa Sanpaolo SpA and Banca Popolare di Milano Scarl are viewed as the best placed.

The write-downs could push some banks to raise fresh cash via capital increases or asset sales, according to Mediobanca analysts.

At the same time, however, the guarantee provided by the government to the so-called senior tranches of the bundled loans would allow banks to use these securities as collateral for European Central Bank's loans, thus improving their funding capability.

Axia's Mr. Spagna said that the outcome of the whole operation at a systemic level would largely depend on the losses banks can sustain when activating the mechanism. He added that smaller cooperative banks are at highest risk because they tend to grant a large proportion of loans to local companies with no guarantees. Unsecured bad loans are typically sold at a few percentage points of their face value, so banks end up booking almost full losses on those loans.

Write to Manuela Mesco at manuela.mesco@wsj.com and Giovanni Legorano at giovanni.legorano@wsj.com

(END) Dow Jones Newswires

January 27, 2016 09:05 ET (14:05 GMT)

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