The new Monte dei Paschi rescue has a moral hazard component

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The new Monte dei Paschi rescue has a moral hazard component
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Your purchase by Unicredit could give creditors a profit, at the expense of taxpayers

Italy’s latest bank bailout offers bond markets a risky moral hazard gamble. Unicredit could buy most of the ailing Banca Monte dei Paschi di Siena, with help from the government. This would be a windfall for creditors, at the expense of Italian taxpayers and European Union rules.

Italian finances are bracing for one last blow from MPS. Aggressive expansion, bad loans and a derivatives scandal saw the world’s oldest bank gobble up € 5.4 billion of state aid in 2017, just four years after another bailout of € 3.9 billion.

It now plans to raise another 2.5 billion euros, and was recently deemed to have negative equity in the most extreme scenario predicted by the EU stress tests.

Rather than recapitalize MPS or liquidate it, the government led by Mario Draghi now wants Unicredit to take over the Siena-based bank. Since its CEO, Andrea Orcel, will only do so if the Government assumes the risks of litigation and bad loans from MPS and guarantees an acceptable return, any agreement could mean a large government dowry or leave the State with the doubtful assets that Orcel doesn’t like them.

European bank resolution rules require shareholders and creditors to take losses before governments inject money, while state aid rules insist that subordinated bondholders contribute to bailouts. Subordinate investors took a hit when MPS was last bailed out in 2017, and in the liquidation of two Venetian banks that same year. In this case, that could mean leaving the bonds with the chunks of MPS that Unicredit does not want, to absorb losses. MPS has, according to Refinitiv, more than 1 billion euros of so-called Tier 2 bonds, a form of capital that absorbs losses.

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However, the deal is likely to protect creditors, Reuters reported last Friday, with Italy arguing that the deal will not require approval as state aid. The bonds could be absorbed by Unicredit, despite having high coupons, or remain in the hands of MPS, but somehow protected by state funds.

Investors are beginning to appreciate this possibility: Tier 2 bonds at 5.375% MPS were trading at the end of July at 75% of their face value, but had risen to 83% on Monday, according to Refinitiv data. Additional earnings will depend on the generosity of Italian taxpayers and the European Commission.