How A Previously Secret Collateral Transformation With The Bank Of Italy Prevented Monte Paschi's Nationalization

The endless Italian bailout story that keeps on giving, has just given some more. It turns out Italy’s insolvent Banca dei Monte Paschi, which has been in the headlines for the past month due to its role as political leverage against the frontrunning Bersani bloc, and which has been bailed out openly so many times in the past 4 years we have lost track, and whose cesspool of a balance sheet disclose one after another previously secret derivative deal on an almost daily basis, can now add a previously unannounced bailout by the Bank of Italy to its list of recent historical escapades.

WSJ reports that in the summer of 2011, when Europe was as it tends to do in recent years, imploding and head of the ECB was still Jean-Claude Trichet, and before Goldman was set to control the troika of key world central banks (via NY Fed’s Dudley, ECB’s Draghi and BOE’s Carney), and more importantly when the ECB was being accused of not being a credible lender of last resort, it was the Bank of Italy that secretly bailed out Italy’s third largest lender with a €2 billion loan. From WSJ:

The €2 billion ($2.7 billion) emergency liquidity loan the Bank of Italy extended to troubled lender Monte dei Paschi di Siena in 2011 was a “classic” central-bank move, although it didn’t appear on the European Central Bank’s balance sheet and no other Italian bank entered a similar deal, a senior Bank of Italy official said Saturday.


“The Bank of Italy acted on its own” said Fabrizio Saccomanni, the deputy governor of Italy’s central bank, when asked about the at-the-time undisclosed securities lending transaction with MPS.

The Bank of Italy, having found itself in the middle of the BMPS derivatives scandal and particularly its lack of oversight and disclosure under former head Mario Draghi, is in full damage control scramble.

Italy’s central bank arranged the loan in October 2011 because MPS was running short of liquidity and had largely exhausted its ability to keep borrowing from the ECB. The loan was aimed at staving off a liquidity crisis at a key Italian bank at a delicate moment in the country’s economic history.


The loan wasn’t disclosed at the time by either the Italian central bank of MPS. In a conference call shortly after receiving the emergency loan, MPS executives described the bank’s liquidity position as sound.


Mr. Saccomanni said that, with its loan to MPS, the Bank of Italy—which was led at the time of the loan by current ECB President Mario Draghi—didn’t violate any rules. The loan was “utterly normal central bank behavior,” he said. He added, however, that no other Italian bank was party to such an arrangement.

Then again, the Bank of Italy said there would be no more secret derivative losses to emerge at BMPS a few weeks ago when the firs two of BMPS’ previously unknown balance sheet Easter eggs were reported (while also lying at the time it had no idea of BMPS’ balance sheet horrors). This was followed promptly by revelations of two more (for now) such arrangements, one of which with US Bank of New York which “allowed the Italian bank to mislead authorities and smoothed through its acquisition of rival Antonveneta, according to a report by the financial police in Italy.”

Therefore one can be excused for believing absolutely nothing that any European banker, whether they have worked at Goldman previously or not, has said.

What is troubling about the Bank of Italy loan, which only took place because the ECB had in fact been a perfectly qualified lender of last resort, only Monte Paschi had no more eligible collateral against which to receive cash from Europe’s central bank, is that it was forced to seek a domestic bailout from the BoI as a true lender of last resort against the most worthless collateral the Siena bank could find. “Under the deal, MPS swapped loans and mortgages for some €2 billion of mainly Italian government bonds.

BMP then proceeded to use the Italian bonds with the ECB and to get Euros in exchange, in effect engaging in precisely the kind of collateral transformation alchemy we described previously in painful detail in “Modern Market Alchemy Explained: Converting Junk Debt Into Supersafe Treasurys Out Of Thin Air“, only instead of converting Junk into “money good” Treasurys, Monte Paschi used the Bank of Italy as an collateral transformation intermediary converting just as worthless impaired loans and mortgages in the first step, and then using the repo proceeds, Italian bonds, as collateral with the ECB, and thus once again evading nationalization.

What the above episode highlights is the fundamental distinction in collateral transformation processes between the US and Europe: while the US has the $35-40 trillion shadow banking system as a conduit for preliminary junk-to-hunk “alchemy”, in Europe it is the regional central banks that serve the role of a decentralized shadow bank (which Europe does not have). The only problem is that while the US shadow banking system is largely a private sector construct, in Europe it is the taxpayers who will be fully impaired when the real value of the worthless rehypothecated collateral is exposed.

Yet one major similarity is that just like in the US, where as we explained collateral transformation takes place entirely off the books, in Europe this step too was completely secret.  “The loan wasn’t disclosed at the time by either the Italian central bank of MPS.” At least in the US whenever the Fed provides direct bailout funding via the Discount Window or through excess reserves, it keeps a track of how much (if not who the beneficiary is of course) and discloses this publicly every week. Not so in Europe, and where it gets even worse is that in a conference call shortly after receiving the emergency loan, “MPS executives described the bank’s liquidity position as sound.” What they didn’t describe is why their liquidity position was sound: because the bank had just engaged in a collateral transformation with the Italian people, who were handed off risk that not even the ECB wanted to touch!

Of course, had the conference call participants known the truth, it is very likely that BMPS would have been long since nationalized.

Yet the worst part of this whole story, is the Bank of Italy’s painfully sad attempt at justification of its actions: First – the bold faced lie that only BMPS was engaging in such “shadow” transformations, which will be true until some other bank is revealed to have engaged in an identical junks-for-hunks repo with the Bank of Italy. And second, the BoI’s childish explanation that because others in Europe do it, it’s fine:

Anyone can do it,” Mr. Saccomanni said, adding that similar transactions have been carried out by other national central banks in the euro area. Some central banks, such as those of Greece and Ireland, have used their own balance sheets for such lending to domestic banks, under the Emergency Liquidity Assistance, a special dispensation from ECB protocols.

Yes, of course others can do it: the point is that all of them disclose it. The weekly updated balance of Greek and Irish ELA loans has been widely used as an indicator of liquidity and funding pressures in Europe.

What Italy did is engage in an identical operation with an insolvent bank, but undisclosed. That the head of the Italian central bank is so naive, gullible or plain stupid, to not realize the difference, is precisely why, as we reported a few hours ago, the Fed has now injected a record amount of dollars into foreign, i.e., European, banks in the last month.

Because if “other national banks in the euro area” do it, the implication of course is that they do so undisclosed. Which also means that nobody has any clue just how insolvent Europe truly is, but one does know that the situation now is as dire as it has always been. Otherwise Monte Paschi would not be set to receive yet another bailout in the form of a €3.9 billion state bond to raise it capital for “regulatory requirement” purposes. And the Fed would not have to use all the reserve proceeds created from QEternity to fund European banks.

Our advice to all depositors, who we can only hope can be counted on one hand, in Monte Paschi – take your money to a safe bank, and since in Italy that is an oxymoron, it is probably wisest to just park what money one may have in the local Banca dei Materassi.

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