World's oldest bank nears breaking point, and it could have major implications for future of EU

Another week, and more concerns about the Italian banking system. A reminder: Monte dei Paschi di Siena (MPS), the world’s oldest bank founded in 1472, has an estimated $55 billion in bad loans on its books and is expected to be among the worst performers in European banking stress tests next week. Shares in the 544-year old bank, the third-largest in Italy by assets, are trading at 8% of book value. Italian officials have been pushing for government assistance to help bail out the bank, but E.U. banking rules require private investors to be wiped out first before there is public assistance. Some private investors are sophisticated institutional investors who were aware of risks, but about half of Monte dei Paschi’s 5 billion euros in outstanding junior bonds are believed to be in the hands of Italian households.

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Earlier this year, concerns about capital levels prompted Portuguese lender Novo Banco SA to wipe out some two billion euros worth of junior bonds, while Deutsche Bank’s uncertainty over its willingness to make optional interest payments on its so-called contingent-convertible (CoCo) bonds raised concerns about its ability to meet obligations on less risky bonds. A backstop fund or private sector solution has been floated by the Italian government to buy bad loans from Monte de Paschi, which are legal within the E.U. framework, but the sheer magnitude of sour debt and destruction of MPS’ equity valuation is making such deals hard to consummate. Getting money from non-performing loans in Italy is also no easy task due to the glacial pace of legal processes in the country. If no deal is reached with the E.U. allowing the government to absorb bad debt, it could lead to a run on Italian bank deposits and a full-blown banking crisis.
 
By July 29, E.U. banking officials are likely to demand an emergency infusion of capital for Monte dei Paschi, which cannot take place without wiping out individual savers. The move would be politically unpopular and the likely nail in the coffin for youthful Italian Prime Minister Matteo Renzi. In the words of a high-ranking Italian official, if Matteo Renzi, known as the "Demolition Man" within Italian politics, penalizes MPS, “he is politically dead an hour later.”

This fall’s referendum on constitutional reforms would be the formal mechanism by which the Italian people would remove Renzi from power, with the nationalist Five-Star Movement waiting in the wings after winning local elections in Rome and Turin. Five-Star Movement’s populist leader, comedian Beppe Grillo, this week likened the Greek bailout to “explicit Nazism,” calling for a nationalization of Italian banks and exit from the euro. Given what’s at stake in the rescue of Monte dei Paschi, Renzi’s greatest hope is that E.U. officials allow for a compromise in order to save the E.U. from further unraveling. The negotiations ultimately amount to a high-stakes game of chicken. Get your popcorn ready.

[Yakov Amihud, Carlo Favero: How to fix Italian banks]
 
[PIMCO: Losses on Italian Non‑Performing Loans: Severity and Solutions]

SOFTBANK-ARM DEAL LEADS M&A WAVE

Deals, deals, deals. Despite growing uncertainty in the global economy, this week brought a wave of merger and acquisition (M&A) activity. Let’s start with the big one:
 
Japanese private equity giant SoftBank agreed to buy U.K. chip designer ARM in a $32 billion cash deal representing a 43% premium over ARM’s most recent closing price. The acquisition is SoftBank’s largest ever investment, giving it control of a company that designs around 95% of microprocessors powering the world’s smartphones. Private equity firms rarely move so far upstream, but the deal indicates a renewed focus from SoftBank on creating a vertically-integrated technology firm capable of reducing lead time in new innovative projects. Because ARM only designs and licenses its microprocessor intellectual property (outsourcing the production of the chips to the companies using them) it carries a small debt load and is viewed as being very nimble.
 
The deal is seen primarily as a bold bet by Chief Executive Masayoshi Son on the so-called “Internet of Things.” More immediately, gaining control of ARM could help SoftBank accelerate its robotics ventures. SoftBank has a robot called Pepper that uses artificial intelligence to read and respond to human emotions, potentially allowing it to replace many human job functions. At the Nikkei Asian Review last month, SoftBank CEO Masayoshi Son said, "I think we are about to see the biggest paradigm shift in human history. The Singularity is coming. Artificial intelligence will overtake human beings not just in terms of knowledge, but in terms of intelligence. That will happen this century."
 
SoftBank shares fell 10% on the deal, which was also viewed simultaneously as a lamentable consequence of Brexit and vote of confidence for the U.K. corporate sector. The ARM deal came together quickly in the two weeks following the referendum, but with ARM shares higher than they were prior to the vote, SoftBank didn’t get much of a discount. However, the hasty completion of the acquisition could also be a harbinger of bargain hunting that could take place due to the cheaper pound, which has fallen more than 10% versus the dollar and 21% against the yen in the last month.
 
The deal will also be viewed as a blow to Intel and Qualcomm in the microprocessor wars. Because of their massive importance to all technology systems, microprocessors are viewed as a national security imperative. China has earmarked $10 billion for microprocessor research and development. While SoftBank is a Japanese company best known for owning Yahoo! Japan and Sprint, it’s also a major player in China’s internet economy, controlling nearly a third of Alibaba, which itself invests heavily in other Chinese internet companies like Weibo. And who knows, maybe the Chinese government could even end up as the eventual buyer of ARM in a few years, speculates SouthBay Research.
 
The SoftBank-ARM marriage wasn’t the only piece of M&A news this week. Unilever agreed to buy Dollar Shave Club for $1 billion in an escalation of its battle against Proctor & Gamble’s Gillette. Dollar Shave Club’s success in eating into Gillette’s market share is the latest example of how e-commerce has leveled the playing field for new entrants.
 
Other prospective deals met opposing fates this week, with the AB InBev-SAB Miller merger getting the blessing of regulators, while U.S. anti-trust officials moved to block unprecedented consolidation in the national health insurance market. Anthem’s (ANTM) proposed purchase of Cigna (CI) and Aetna’s (AET) proposed takeover of Humana (HUM) would reduce competition, raise prices and stifle innovation for U.S. consumers, said the U.S. Department of Justice in its anti-trust lawsuit filing.
 
Finally, on Friday news broke that Yahoo! (YHOO) was in exclusive negotiations with Verizon (VZ) to sell its core business for around $5 billion. While Yahoo! had several earnest bidders for around the same figure, Verizon is seen as a good long-term home for Yahoo!’s once-proud content operation as the latter tries to create a vertically integrated media and the telecommunications company. AOL CEO Tim Armstrong in particular is seen as the ideal candidate to restore Yahoo!’s former glory.  

BREXIT WEIGHS ON U.S. ECONOMY

The first major signs of distress have hit the U.K. economy following Brexit as the kingdom’s Markit composite purchasing managers index (PMI) fell to 47.7, an 87-month low. The contraction in economic activity was the result of order cancellations and investment project postponements amid currency volatility and uncertainty over the U.K.’s ongoing relationship with the E.U. The figure represented the sharpest slowdown in the U.K. economy since April 2009. Export-related statistics usually offer some lag, so the full effect of Brexit may not be felt for months.
 
In the U.K. real estate market, Brexit has triggered a dramatic increase in asking-price reductions. The number of price cuts surged by 163% in the 12 days following the referendum compared with the 12 days beforehand, according to research firm LonRes. Sales of London homes under construction also fell 34%.
 
The rise in economic pain and anxiety is not limited to the U.K., though. German investor confidence fell to a four-year low on Brexit fears, while Euro-area consumer confidence also declined.
 
Brexit has caused the International Monetary Fund (IMF) to trim its growth forecasts for 2016 and 2017, while Ireland could be facing its biggest foreign crisis in 50 years because of its close economic ties with Britain.

Meanwhile, Deutsche Bank has educated guesses on where all those London bank jobs could be heading.

WALL STREET COST-CUTTING BOOSTS PROFITS

Q2 earnings season is off and running, with corporate profits expected to shrink for the fourth consecutive quarter.
 
Goldman Sachs (GS) this week reported Q2 profits soared on strong bond trading results. Despite a “challenging backdrop” for revenue, cost-cutting measures boosted the firm’s profits by 78%. Expense reduction has been a common theme for banks this year. Bank of America (BAC) also topped earnings estimates despite seeing profits shrink from the year ago period, and has promised to cut another $5 billion in costs by 2018 in response to the persistently low interest rate environment. Morgan Stanley also topped profit estimates on bond trading gains despite an overall drop in revenue. BBVA, Spain’s second-largest bank, announced plans to eliminate 2,000 jobs or more. Running out of jobs to cut, many banks are now also cutting executive pay.
 
Within tech, Microsoft earnings beat expectations as CEO Satya Nadella’s turnaround continues to take hold. The company is becoming a serious force in the cloud, while its Bing search engine is no longer a complete joke.

THE AMERICAN ECONOMIC EXCEPTION

While Europe has seen a dramatic decline in sentiment, the U.S. economy keeps plugging along. A lackluster housing market has begun to show signs of life, with existing home sales hitting their highest level since 2007 on Thursday. New home construction also rebounded in June, with J.P. Morgan pointing out an uptick in the build out of single-family homes versus apartments is reflective of Americans' increasing wherewithal to buy rather than rent.
 
The resurgence in real estate prices has, however, prompted many to wonder whether low interest rates could be cultivating another housing bubble. In the U.S., some observers contend U.S. real estate is not overheating, but is merely an expensive market, while on the other hand in places like Canada, Australia and Sweden, extraordinarily low rates could be giving rise to housing bubbles.
 
The U.S. has so far been relatively impervious to pain from Brexit, causing Federal Reserve officials to gain confidence they can raise rates this year, although the market still believes there is less of a 50% chance of monetary tightening by year-end. Short-term Treasury yields have rebounded but remain in a historically low range, with the yield curve showing few signs of steepening materially. Tim Duy, a University of Oregon professor and noted Fed expert, believes the Fed can’t and shouldn’t raise interest rates.
 
Global central banks, meanwhile, are eyeing moves in the opposite direction. New U.K. finance minister Philip Hammond urged the Bank of England (BOE) to take the first steps to steer the British economy through its Brexit shock, while European Central Bank (ECB) President Mario Draghi hinted he may boost stimulus later this year. With the Nikkei strengthening markedly over the past month, Japanese policy officials are also more likely to double down on dovish “Abenomics.”

FURTHER READING

In Turkey, more than 60,000 military, police, educators and other public officials have been detained or fired in response to the attempted military coup, with Turkish stocks and bonds extending their retreat after an S&P rating cut. Read: The geopolitics of Turkey’s failed coup.
 
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China’s local debt problem goes global.
 
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