Italy's 10-year sovereign bond yield has risen from 1.78% at end of April and prior to the general election to 3.66%. That's the highest since the beginning of 2014 and the yield is still rising. Domestic banks and Italian life insurers are major holders of these bonds, with life insurers having a massive 47% of their assets under management in 2016 in Italian debt. That's a big problem if Italian yields stay elevated.
To make matters worse, the bond selloff is creating an equity selloff too. Italy’s FTSE MIB stock index fell to its weakest since April 2017.
It's the banks where the biggest problems lie, since they are at the heart of the financial system. They hold 387 billion euros of Italian government debt. So, Italian banks are quickly developing a mark-to-market problem that will destroy their capital base and create an Italian banking crisis. As the battle between Brussels and Rome over fiscal rules intensifies, this is going to be a key point of leverage over the Italian banking system.
The Italian bank - government nexus
Let me remind you of my comments from two years ago about what's wrong with Europe's banking system:
Now, let’s remember the constraints here. During the sovereign debt crisis, banks and sovereign credits became co-mingled because banks owned lots of sovereign debt. And so as sovereign debt soured, so too did the condition of euro banks. This eventually required a bailout of Spanish banks via the state, making clear that – given the lack of a common bank resolution mechanism – the contingent liabilities of banking systems fell to the state. The other major eurozone bubble economy, Ireland, suffered a similar fate after the sovereign was forced to bail out its banking system, mandating a Troika bailout for the state in turn. This is a situation that no one wanted repeated. In fact, if bail-ins – like the one
us would become the model – were in effect, Ireland never would have needed a bailout. As people like myself suggested at the time,
We have known for some time that most European banks are zombies, unable to increase lending because of a lack of capital. Buiter said so explicitly in 2013 during the Cyprus bail-in. And the lack of growth in Italy has made this problem far, far worse. The situation is not much different today in the unreformed and balkanized EU banking system. So, as Italian government bond yields increase, Italian banks take mark-to-market losses. And this erodes capital. Ostensibly, after years of undercapitalization, the Italian banks are well capitalized enough for the European regulators. But, they have a huge slug of non-performing loans on their books that are not subject to mark to market accounting.
If they take mark-to-market losses on government debt holdings, eventually have to raise capital and cut lending to the real economy. In a worst case scenario, that cut will cause financial distress in the real economy in Italy. Losses from non-performing loans could crystallize as yields march higher, ending in an all-out Italian bank crisis.
The key takeaway: just because there's been no asset bubble in Italy as there was in Spain and Ireland a decade ago doesn't mean that you can't get a banking crisis. Italy's slow growth and high percentage of non-performing loans make its banks vulnerable even so, especially in a case where they are taking huge mark-to-market losses on one of their main balance sheet assets, Italian government debt.
Is mark-to-market the problem?
If you recall, it was when the US suspended its mark to market rules that things really turned around during the housing bust. Market-traded securities are marked to market whereas loans held to maturity are not. That's why, during the crisis, it was the large international institutions which held lots of mortgage-backed securities took the lion’s share of writedowns, despite the low percentage that marked-to-market assets represented on bank balance sheets.
In a market meltdown, where a traded asset declines significantly below fair market value, this can create a death spiral for the institutions most levered to that asset. That's what we saw in MBS in 2008. That's what we saw with Spanish government debt in 2013. And that's also what we could see with Italian government debt in 2018.
The big advantage the Italians have over the Spanish is that they never had a housing bubble. So, if you get rid of mark-to-market rules on Italian government debt, the problem goes away. But this is a key point of leverage the EU has over the fiscal outcomes in Italy. Brussels wants mark-to-market accounting to help force the Italians into line, just as they do not want to see the ECB buying up Italian debt via quantitative easing, as that goes counter to the EU's government assistance rules.
So, while mark-to-market rules are the big problem for Italy, they offer no solution here because the Italian government is at loggerheads with the EU.
This is a political crisis that is creating an economic and financial crisis
The Italian banks are basically hostages in the political crisis developing after Italy elected a eurosceptical government which is now flouting Brussels' rules. You solve the political crisis and the threat to the banks goes away.
The problem: vice-premier Matteo Salvini of the Italian Lega is saying: “Behind this surge there is old-style manipulation by speculators, like George Soros 25 years ago, to buy Italian assets at bargain prices. But whoever is speculating is wasting their time. This government is not turning back.” And Luigi di Maio, the Five Star leader, also Italy’s vice-premier, is saying “It should be very clear that the government will not retreat. This is a budget to repair the injuries suffered by the Italian people, who have been tricked by the banks.”
That doesn't give investors any confidence that this problem is going away. So, expect the selloff in Italian debt to continue until Italy caves.
My position remains the same as it was a week ago, the main difference now being that we have a showdown:
Italian bonds will sell off even more. And faced with a worsening economy and the potential of private sector defaults, I believe the Italian government will have to respect the stability and growth pact in some form.
So, over the short-to-medium term, this is a fake crisis in Italy. Italian government debt will only be allowed to sell off so much before we see official intervention. The real threat is longer-term. A stand-off could do real damage to the Italian economy, enough so that it raises the desire of Italians to exit the euro. But we would need to see a doubling in pro-Italexit sympathy for a euro exit scenario to be a real threat. And we can’t get there overnight.
In the meantime, expect Italian government bond yields to remain elevated, causing Italy to underperform economically for the foreseeable future. Recession in Italy is not an outlier scenario.
It will be interesting to see how the ECB reacts.