Monte dei Paschi di Siena is the third largest bank in Italy, after Unicredito and Intesa. It is famed as the oldest bank in the world and its most elegant renaissance headquarters in Siena. Of late Monte has become infamous for being the only bank out of the 51 tested to have all its capital wiped out in the 2016 EBA Stress Tests.

The bank has an outstanding convertible that has been trading at deeply distressed levels as shown in the chart below.

MDP Chart

Terms of the FRESH Convertible

Issuer: Mitsubishi UFJ Investor Services & Banking (Luxembourg) S.A. (which replaced The Bank of New York Mellon (Luxembourg) S.A., as fiduciary issuer on 10 October 2016)

Underlying credit: Monte dei Paschi di Siena (BMPS IM); via a fiduciary swap agreement

ISIN: XS0357998268
Issue date: 8th April 2008
Issue amount: Euros 1bn
Denominations: Euros100,000
Law: Variously Luxembourg and Italian law (Courts of Milan)
Maturity: 30th Dec 2099 (mandatory conversion at maturity)
Coupon: 3 month Euribor +4.25% payable quarterly
Type: Non-cumulative
Current coupon: The coupon has been suspended since July 2012
Conversion price: 6,774.24
Parity: 0.03
Current Price (22 Nov 2016): 13%
Yield: N/A (coupon has been suspended since July 2012)

 Some background on the bank

The bank recent history is chequered to say the least.  Monte dei Paschi’s problem has been one of non-performing loans and poor management. In 2014 the former Chairman, Chief Executive and finance chief were all found guilty of misleading regulators over derivative trades and were each sentenced to 3 1⁄2 years in prison.

Resolution of non-performing loans in Italy is very slow compared with other European countries. Foreclosure takes on average 56 months compared to 20 months in France and 9 months in Germany. And even Greece can do it in 24 months. In April 2015 a Deutsche Bank report made the point that:

Both supply and demand factors are behind the slow pace of NPL resolution. Factors limiting supply relate to the lack of incentives for banks to write off and sell NPLs (accounting issues, tax regime, etc), while the main factor limiting demand is the lengthy nature and inefficiency of the judicial system.

The Italian government has promised reforms to speed up the process of resolution, including creating a bad bank to buy non-performing loans from Italy’s banks. At the beginning of September Bloomberg reported:

Italian Finance Minister Pier Carlo Padoan said the government is in final talks with the European Commission to create a bad bank to buy problematic loans from lenders, a measure to free up lending as the country emerges from a record-long recession.

However, to date the long period of foreclosure in Italy has led to the piling up of non- performing loans on the banks’ balance sheet (20% of Monte’s balance consists of impaired loans). This presents problems. Amongst other things it uses up capital, even if the loans have been correctly provisioned for. As Deutsche Bank says in their report:

banks’ cost of credit would reduce by between 7 and 28bps per year (depending on the bank) for every year shortening of the NPL life

Monte paid back Euros1bn of Monti (sic) bonds in the 1st quarter of 2015. The Monti bonds provided capital support from the government. This has removed the thorny issue of state aid.

Monte settled a case (in September 2015) with Nomura over losses in derivatives trading whereby the Japanese bank has agreed to pay Euros440 million. This had a positive impact on Tangible Equity of EUR 257 mln and added 70bps to Basel 3 CET1 (fully-loaded).

In 2015 the bank  stated that the EU would still like it to find a partner but they were under no time limit or compulsion. Exane commented on 28th September 2015 that the Monte will not be “forced” into a value destroying deal by the regulator.

Then there were rumours that there would be a merger between some or all of Unicredito, Intesa and Monte, but all the banks have denied this and it came to nothing. Then the 2016 EBA Stress Tests, which the bank failed spectacularly, brought matters to a head and demand from European regulators for a concrete plan to stabilise the bank. This has led to the recent announcement of a plan to raise Euro 5bn in capital from a combination of a liability management exercise to convert subordinated debt into equity and new equity fundraising.

Risk in buying the convertible

This convertible bond counts as a deeply subordinated issue. Indeed holders are technically equity holders as the shares have already been issued and just await either conversion or the 2099 maturity date before they are handed over to bond holders. Bond holders effectively own a) the shares and b) the contract to a fixed income (Euribor+4.25%) income stream from Monte dei Paschi until such time as there has been a conversion. The equity is worth virtually nothing but the contract for the equity stream is valuable so long as it does not become extinguished via a conversion.

In the event of a failure of the bank or a resolution scheme being put in place by the regulator you would not expect to receive any recovery. This would probably also apply to less deeply subordinated issues, so you could argue that you might as well be hanged for a sheep as a lamb.

At current deeply distressed levels in essence there are two forms of risk that holders of this convertible are taking –

  1. the risk as to when or whether the suspended coupon will start to pay again and;
  2. the risk that in some way your principal could be written off even though the bank continues without a resolution scheme occurring.

The coupon

The coupon was suspended in July 2012 and has not been paid since. With regard to the payment of interest it says on page 16 of the prospectus:

4 Interest

(b) Interest Payments

vi) In respect of each Interest Period, the Company is required under the Usufruct Agreement … to pay an amount equal to the relevant Interest Amount if (A) the Company has, according to the last available unconsolidated annual accounts (the “Accounts”) approved by the Company before the relevant Interest Payment Date (the financial year to which such accounts relate being a “Relevant Financial Year”), distributable profits (“Distributable Profits”) that would be available for the payment of a Distribution on any class of its share capital (ordinary shares, saving shares, preferred or preference shares) or (B) the Company has declared or paid Distributions on any class of its share capital based on the Accounts; provided that, if the aggregate amount of the Company’s Distributable Profits (calculated as aforesaid) and/or its Distributions for the Relevant Financial Year are less than the aggregate of the Interest Amounts falling due in the one-year period following the approval of the Accounts, the Company shall be required to pay only a proportion of the relevant Interest Amount calculated on the basis of the aggregate amount of such Distributable Profits and Distributions for the Relevant Financial Year and the aggregate amount of such Interest Amounts.

(vii) Interest Amounts will accrue and be payable, as provided above, on a noncumulative basis. …

Under definitions in the prospectus:

“Company” means Banca Monte dei Paschi di Siena S.p.A.

* Usufruct agreement “right to the use and profits of the property of another without damaging it,”

This clause relating to when coupons must be paid is somewhat vague. In particular whether the distributable profits coupon pusher refers to 12 months profits or the accumulated position. Personally I can see a decent argument that the accumulated position was intended because this is what legally distributable profits is based on. However, others I have spoken to consider the reserve pusher relates to the financial year’s profits rather than accumulated.

There is some fascinating further colour on this clause as it is involved in the Monte fraud and bribery scandal. It seems that the originally proposed terms had a more mandatory coupon without the profit restriction but the regulators saw this as too bond like and so insisted on the profit restriction. However, BNY foresaw problems getting the issue away to investors with this change in coupon protection and so Monte gave them an indemnity over it which they did not disclose to the regulators –

I think this supports the view point that it is the distributable profits for the year which are relevant and not the accumulated position. If this is correct then losses are not carried forward or cumulated and do not have to be made good before the coupon is resumed (unlike with some more recent issues). Past losses are left in the past. The following additional points should be noted.

1) If there are some distributable profits but not enough to cover the entire coupon then there will be a partial payment of the coupon.

2) Payment is dependent on retrospective performance. In other words a distributable profit in 2016 would trigger a payment in 2017, and likewise a loss will trigger non-payment one year later.

There is a further wrinkle in the way in which profits are apportioned before any become distributable. This is because under Article 33 of the Bank’s Articles of Association, net profits reflected in its financial statements are assigned as follows:
(a) 10% to the legal reserve until this reaches an amount equal to 1/5 of the share capital;
(b) to the creation and growth of a statutory reserve for no less than 15% and at least 25% once the legal reserve has reached an amount equal to 1/5 of the share capital;
(c) the remaining earnings are available for distribution in favour of the shareholders subject to a resolution by shareholders at a Shareholders’ Meeting.

The essential point is that with a price in the low teens, even if there is a delay of several years beyond 2017 before the coupon is resumed, you can still more than justify a purchase at the current price.

Therefore the real focus should be on risk to –

Risk to Principal

The contract the convertible holders have with Mitsubishi UFJ Investor Services & Banking (Luxembourg) S.A. (which replaced The Bank of New York Mellon) is that they must pass on the cash flow they receive from Monte dei Paschi in the form of coupons / interest as explained above. Therefore as long as that contract is in place, holders have a very cheap asset. But at the same time after falls in the share price and deeply discounted rights issues, the fixed number of shares that back the convertible mean that parity is a paltry 0.03%. In other words should a holder of Euros1,000,000 of the convertible have their bond converted, he would hold shares to the value of only Euros300. The risk to your principal (beyond bank failure or resolution) is therefore the risk that there is a forcible conversion into shares.

This is what the prospectus says (Page 18).

5 Automatic Exchange

The Bonds may not be redeemed otherwise than in accordance with this Condition 5, Condition 6, or Condition 14. Redemption pursuant to this Condition 5 is subject to Condition 7.
(a) Automatic Exchange due to Share Price

If at any time during the Exchange Period …. The Exchange Security Price of the Predominant Exchange Security …exceeds 150 per cent. of the Exchange Price … each Bond will automatically be redeemed.

[Obviously this is neither a threat nor problem!]

(b) Early Automatic Exchange following an Event of Default
Following any notice by a Holder delivered pursuant to Condition 14(a) or pursuant to Condition 14(c), the Issuer will, within 5 Business Days of receipt of such notice, give notice that an Automatic Exchange has occurred … and will redeem each Defaulted Bond on the Automatic Exchange Settlement Date

[It is already assumed in the event of a default that recovery would be nil so this clause is not relevant].

(c) Early Automatic Exchange following a Capital Deficiency Event of the Company
Under the Usufruct Agreement the Company is obliged to notify the Counterparty and the
Issuer of the occurrence of a Capital Deficiency Event … The Issuer shall notify Holders of the occurrence of a Capital Deficiency Event and that accordingly an Automatic Exchange has occurred … and the Bonds will be redeemed on the Automatic Exchange Settlement Date

Under definitions on page 4:

“Capital Deficiency Event” will be deemed to have occurred if:
(i) as a result of losses incurred by the Company, on a consolidated or nonconsolidated basis, the total risk-based capital ratio (coefficiente patrimoniale complessivo) of the Company, on a consolidated or non-consolidated basis, as calculated in accordance with applicable Italian banking laws and regulations, and either (A) reported in the Company’s reporting to the Lead Regulator (currently Matrice dei Conti) or (B) determined by the Lead Regulator and communicated to the Company, in either case, falls below the then minimum requirements of the Lead Regulator specified in applicable regulations (currently equal to five per cent. pursuant to the Nuove Disposizioni di Vigilanza Prudenziale per le Banche, set out in the Bank of Italy’s Circolare no. 263, dated 27 December 2006); or
(ii) the Lead Regulator, in its sole discretion, notifies the Company that it has determined that the Company’s financial condition is deteriorating such that an event specified in (i) above is likely to occur in the short term.

I feel this provision 5(c) [Early Automatic Exchange following a Capital Deficiency Event, ‘CDE’, of the Company] presents the main risk of early automatic exchange. Unfortunately the clause and associated defined terms (such as definition of capital) have not been clearly drafted and so it is not certain to my mind how the massive regulatory changes we have seen since issue in 2008 apply. There was no sequential stress testing nor stress test passmark at the time so one question is whether the bank could argue that not having sufficient core capital to meet the regulators current stress test passmark constitutes a CDE? From our experience of Lloyds ECNs I could certainly imagine a good QC trying that line of argument !

My reading is that a stress test fail alone would never be enough to force conversion. It would need to be an actual ‘real’ breach of minimum capital ratios. Of course a real breach cannot be ruled out. Bloomberg have reported a recent JP Morgan note which suggests that unrealised losses on Monte’s large holdings of peripheral Euro sovereign could tip them close to the 8% CET1 minimum. See –

However, the latest (30 Sept 2016) disclosed CET1 ratio is 11.5% –

MPS regulatory capital

And the bank’s Q3 2016 statement provides the following additional information –

In light of the above, capital ratios on a transitional basis at 30 September 2016 are therefore decreased compared to 31 December 2015, albeit remaining above the minimum threshold required by the Supervisory Authority under SREP.

(d) Early Automatic Exchange on Non-Equity Offer
The Issuer will …give notice that an Automatic Exchange has occurred and .. redeem the Bonds on the Automatic Exchange Settlement Date

[It is not clear how a Non-Equity Offer would occur. However, in the case of a cash only offer for the shares of Monte dei Paschi, the following would apply:]

Page 28

If any Offer Consideration is not in the form of Listed equity … the Counterparty shall realise.., such assets and the resulting proceeds .. shall be applied… in purchasing the maximum number practicable of such Listed equity securities which will be added to and form part of the Exchange Property as if the Issuer was the holder of the relevant Exchange Property.

[i.e. the cash from any takeover would be used to buy shares in the company/ bank that was taking over Monte and these shares would then replace the existing shares of Monte that underlie the convertible].

(e) Early Automatic Exchange following an Increased Burden Event or a Tax Event Following the occurrence of a Tax Event or an Increased Burden Event, the Issuer or the Counterparty.. shall within 5 Business Days of receipt of the relevant legal or tax opinion give notice that an Automatic Exchange has occurred

… [BUT] …
If the Issuer gives such notice relating to a Change in Law or Interpretation Tax Event … each Bondholder will have the right to elect that his Bond(s) shall not be redeemed on the Automatic Exchange Settlement Date and payment of all amounts in respect of such Bond(s) shall be made subject to the relevant Withholding.

Relevant definitions are –

“Increased Burden Event” means the receipt .. of an opinion of a nationally recognised law firm in any Relevant Jurisdiction, … to the effect that [following a change in the law].. there is a more than an insubstantial risk that the Issuer, the Counterparty or any of their affiliates or the Company is or will be subject to more than a de minimis amount of administrative, compliance or regulatory burden or cost in relation to its respective obligations under the Bonds, the Swap Agreement or the Company Swap Agreement, as the case may be.

“Increased Tax Event” means the receipt by the Issuer or the Counterparty… of an opinion of any nationally recognised law firm or other tax adviser in any Relevant Jurisdiction … to the effect that…there is a more than an insubstantial risk that the Issuer, the Counterparty or any of their affiliates or the Company is or will be subject to more than a de minimis additional amount of income taxes due to a change or modification of the deductibility of the payments made under the Bonds, the Swap Agreement or the Company Swap Agreement, as the case may be.

[Nearly all bonds will have a tax event call and calls occurring because of such an event are extremely rare. There is also the protection (at the cost of paying for the increased costs/ withholding tax) for a holder of electing not to have the bonds called. Therefore this eventuality does not constitute a significant risk].

What happens in the event of a takeover? Logic would dictate that the shares underlying the convertible (BMPS IM) would be replaced by the new shares. Even though such an eventuality is not specifically referred to, I cannot see any justification for this to trigger an automatic conversion. It was suggested to us by one analyst that there might be an argument that convertible holders could decline the takeover forcing the call, at par, of the convertible.

Recent Developments

On 15 November 2016 the bank announced  a massive liability management exercise (involving exchange of subordinated bonds for equity) targeting about 5 billion euros of the bank’s subordinated bonds in an attempt to avoid being subject to the Bank Recovery & Resolution Directive (BRRD). The exchange terms, which are at a healthy premium to recent market prices albeit in equity, have been received as ‘generous’ for Tier 1 with questions marks over Tier 2. Levels are as follows:

– 20% for a very small issue of FRESH Convertible (not the ones I am writing about)

– 85% for other Tier 1

– 100% for Tier 2

Despite having the stick of resolution as the consequence for poor take-up MDP has opted to make the terms attractive in order to garner a high acceptance level. This is in contract to the approach taken by Irish bank’s back in 2011 where aggressive coercion (which has subsequently been ruled illegal) was used in order to get high acceptance of low offer levels which enabled the bank’s to book capital through the gain on exchange as well as the equity raised.

Another factor in the generous terms is perhaps the large number of retail investors who hold up to 2 billion Euros of MDP’s subordinated bonds. Noises have been made by the Italian government that retail investors should be spared from bail-in under BRRD because of the impact it would have on the Italian economy and, I suspect, Prime Minister Matteo Renzi’s chances in the imminent constitutional referendum – the outcome of which may prompt his resignation.

The Euro 1 billion FRESH Convertible (ISIN: XS0357998268) which is the topic of this post was not included in the offer but instead referred to as follows-

The Bank is also evaluating the possibility to launch an offer in respect of the €1,000,000,000 Floating Rate Exchangeable FRESH Bonds due 30 December 2099 (XS0357998268) issued by Mitsubishi UFJ Investor Services & Banking (Luxembourg) S.A. (which replaced The Bank of New York Mellon (Luxembourg) S.A., as fiduciary issuer on 10 October 2016) (the “FRESH 2008 Offer”). In respect of this, analysis of a technical nature is being carried out, which is expected to be concluded shortly, as well as an exchange of information with the supervisory authorities in relation to regulatory matters and prospective implications. Should such evaluations have a positive outcome, the FRESH 2008 Offer may be launched and, if launched, would be launched at the same time as the LME Offers.

I understand that MDP was / is negotiating with a group of funds the group of funds led by Attestor who were / are asking for a 50% conversion price into equity based on a 5 billion Euro valuation of the bank post recapitalisation. The FRESH Convertibles currently count 78% CET1 and 22% AT1 capital for regulatory purposes so if the bank were to offer more than a 22% exchange price FRESH holders would be getting a better deal at the expense of diluting other participants in the capital raise.
Incidentally there is a Euro 74 million indemnity deduction on Monte dei Paschi’s balance sheet that can be released if they get the entire bond to exchange. In this case the bank could pay approximately 29.4c in new equity without diluting others.

Frustratingly the situation is evolving as fast as I can research and write and the bank has just announced as follows –

L’operazione, tuttora in corso di approfondimento con le Autorità, prevede che ai detentori dei titoli FRESH 2008, che aderiranno all’offerta FRESH 2008 entro il giorno di chiusura della stessa manifestando la propria volontà di esercitare il proprio diritto di conversione del titolo in azioni MPS, sarà attribuito un importo in denaro finalizzato alla sottoscrizione di azioni di nuova emissione, e quindi – in ultima istanza – un numero di azioni addizionale rispetto a quanto dovuto ai sensi del relativo regolamento. L’ammontare dell’importo offerto è assunto pari al 23,2% del valore nominale dei titoli FRESH 2008.

Suggesting an offer of 23.2% has been assumed in the bank’s submission to its supervisors. I am not clear at this stage whether negotiations with holders are still ongoing.

To get the actual recovery the offer level you need to take a view on what Monte will be worth in the future. A 5 billion Euro valuation looks on the high side but 3 billion Euros looks more reasonable. Based on an offer of 23.2c in equity this would imply a 14c recovery on the FRESH Convertibles which is pretty much the market price at the time of writing.

On this basis I cannot see an offer at 23.2 being attractive to most holders of the FRESH unless the bank produces a large stick to beat them with or a large number of holders also hold other targeted securities and are taking an overall view. So, to me, holder of the FRESH Convertibles would likely rather holdout and keep 100 FRESH rather than 23.2 equity on the basis that the FRESH are going to have to pay before the equity can and that their conversion risk is greatly reduced post recapitalisation.

There are also huge execution risks with the exchange and recapitalisation. For example –
– Can the bank get a quorum (20%) at the EGM on the 24th November to approve the deal. [UPDATE 25 Nov 2016: the Bank has announced that the shareholder meeting was quorate and that all resolutions were passed]
– Will the bank get a high enough take-up in the LME. The holdout value for the Tier 2 looks high and there is the added complication of offering a large number of retail bondholders non-paying equity which they will not want. Reminds me of where I started in the Co-op Bank recapitalisation negotiations but I digress …
– What will happen in the Italian referendum on 4 December? It is not looking good for Renzi even before you apply the current trend for kick the establishment popular votes.
– Can the bank find an anchor investor in the equity raise? The Qatari Investment Authority is reported to be interested.
– Can the bank persuade other investors to come in at a €5bn valuation, especially as LME participants will have a lower entry point if they bought bonds below par and will sell their equity.
– Can the bank really do an equity raise in December.
– What happens if there is a delay. But perhaps I am being too British about this. As Oliver Butt, from City & Continental, who has helped me with this article and knows a good deal more about Italy than me puts it –

As they say in Italy “Ordine nel disordine.” (Order in the disorder). Disorder or chaos is the Italian constant and you only get real chaos when the constant against which everything can be measured changes. So we need more chaos to maintain stability. Or as Lampedusa’s character says in Il Gattopardo, “Se vogliamo che tutto rimanga com’è bisogna che tutto cambi”. For everything to remain the same everything needs to change.

My overall view is that Monte will probably somehow find a way to muddle through eventually, but delays are very likely which means the entry point may be better in future.

If you have made it this far and would like to discuss the Monte dei Pashi situation please have your say on my fixed income discussion board. Or if you are not allowed to post in public send me an email  at