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The Dangerous Game Investors Are Playing – And Why You Shouldn’t

1 | By Shah Gilani

Banking shares across Europe are rallying, especially share prices of Italian banks.

It’s not because they’re in good shape, or netting more profits, or have great yields.

They’re rallying because the possible collapse of Italy’s Banca Monte dei Paschi di Siena and the contagion fears that come with a big bank failure, have been diverted, for now.

Investors who had shed bank shares, driving their prices into the bargain bin, are now jumping back into these same banks hoping to pick them up on the cheap.

But getting into European banks right now is a dangerous game because nothing is certain.

European Bank Shares Are Rallying… for Now

While bank shares rallying on the prospect of another state-sponsored bailout of Monte dei Paschi, Italy’s third largest bank by assets, and the world’s oldest bank (founded in 1472), seems crazy, it’s not in the short-run.

That’s because Too Big to Fail banks have been good bets every time they crash and burn and get bailed out by their governments and central banks.

However, beyond this latest market pop, Italian banks and big European banks are a dangerous bet.

All the news lately is focused on Banca Monte dei Paschi di Siena (MPS) because it has until the end of 2016 to recapitalize itself after failing European bank stress tests this summer.

In order to meet required capital standards, the bank put together a plan to raise €5 billion of cash and sell €28 billion worth of non-performing loans (NPL).

Part of the €5 billion in cash needed to bolster MPS’ equity capital is expected to come from Qatar’s Investment Authority, the country’s sovereign wealth fund and already a beleaguered investor in MPS. Underwriters of the equity offering hope a large investment by Qatar will spur other investors to pony up fresh cash.

As of today, Qatar hasn’t stepped up with any commitment of cash, which the offering’s syndicate of underwriters says partly constitutes “adverse market conditions” that relieves the underwriters of having to raise any money.

Meanwhile, there haven’t been any takers for packages of MPS’s €28 billion worth of bad loans.

And that’s good news for investors, believe it or not.

Don’t Believe the Hype – Euro Banks Are Still a Danger

Because Italy and the European Union can’t afford to let MPS fail, it now looks like the state will lend the bank whatever it needs to stay alive and buy time to hopefully sell off bad loans and entice equity investors off the sidelines.

This isn’t the first time MPS has needed a bailout.

It was on the brink of failure and technically insolvent in 2009. It failed 2011 stress tests and needed €3.3 billion to fill a capital hole. It managed to stave off failure, but by 2013 had to borrow €4 billion from the government to keep its doors open. A €5 billion capital raise in 2014 helped pay down the government loan by €3 billion and another €3.3 billion raise in 2015 was enough to pay back the rest of its government bailout loan, keep the bank’s 25,000 workers employed and its 2000 branches open.

Obviously, MPS is failing again.

So why would anyone buy shares in the bank? Because it’s getting bailed out again?

While it’s not a “done deal” and the government hasn’t yet ponied up the money MPS needs, it has to.

Otherwise, the failure of MPS would likely immediately trigger the failure of three teetering mid-sized banks Popolare di Vicenza, Veneto Banca and Carige, and four small banks that had to be rescued last year: Banca Etruria, CariChieti, Banca delle Marche, and CariFerrara.

If the state doesn’t give MPS the cash it needs, the bank would be subject to a bail-in, where depositors who have more than €100,000 in cash at the bank can have their money taken by the bank and turned into equity shares. And some €2 billion worth of subordinated debt held mostly by savers and pensioners who bought MPS bonds for their yield could have their bonds swapped for equity.

The likelihood of a run on most Italian banks, as depositors feared their cash would be confiscated, would decimate the banking system in Italy and spread panic across Europe.

It’s entirely possible.

Especially now that Italians voted “no” on the referendum that would have changed their constitution and reduced the size of government, which triggered the resignation of Prime Minister Matteo Renzi, and sets the stage for a caretaker government and new elections that could bring populist parties into power who might let some banks fail.

The prospect of further political upheavals in Italy, as their banks teeter in the balance, doesn’t constitute a buying opportunity in the banking sector to me.

All across Europe, banks are in trouble. Collectively, European banks are sitting on €360 billion worth of non-performing loans, while the sum total of equity capital on their books is only €225 billion.

They’re in big trouble.

As a trader, it’s fine to make short-term, event-driven bets like MPS getting bailed out and other banks rallying along with MPS shares rising.

But as an investor, buying these suddenly popping European bank shares isn’t for the faint of heart.

You’ve been warned.

Sincerely,

Shah

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