October 22, 2018 / 1:15 PM / 9 months ago

Market turmoil forced Italy to tighten bad loan guarantee scheme

MILAN (Reuters) - The turmoil in Italian asset markets since May has forced Rome to tighten a state guarantee scheme devised to help banks offload bad loans, making it costlier for lenders, an EU Commission document showed.

FILE PHOTO: The Italian flag waves over the Quirinal Palace in Rome, Italy May 30, 2018. REUTERS/Tony Gentile/File Photo

Regulators and investors see efforts to clean up bad loans as crucial for the full recovery of the Italian banking sector, which is again in the market’s crosshairs due to the falling value of its large sovereign bond holdings.

Italy introduced the ‘GACS’ guarantee scheme in 2016 to help banks tackle a 360 billion euro ($414 billion) pile of problem loans left behind after a deep recession.

The Commission on Aug. 31 granted a final six-month extension to the scheme, which allows banks to buy a guarantee from the state at market prices to ease sales of bad loans repackaged as securities.

The price of the guarantee reflects the cost of insuring debt issued by a basket of Italian corporates and financials against default, as measured by credit default swaps (CDS).

However, CDS on Italy’s debt ITGV5YUSAC=MG have nearly tripled since mid May, when investors were spooked by the prospect of a new anti-establishment coalition government with profligate spending plans and anti-euro rhetoric.

In approving the extension to the GACS scheme, the Commission noted that such a sharp increase in CDS levels, including a 40 percent rise on one day, was a very rare event.

“The fact that CDS premiums have not eased considerably since then could be interpreted as a ... change in the market, representing a fundamental reassessment of risks inherent to Italy,” the Commission said.

To avoid breaching EU state aid rules when seeking the renewal, Italy proposed calculating the CDS average, which is used to price the GACS, over a period of two months, instead of the six months used previously, when the difference between the two calculations exceeds a certain threshold.

The shortening of the calculation period prevents Italian banks from benefiting from the lower CDS levels before the market sell-off.

A person working on a bad loan sale said the changes translated into lower prices for the bad loan portfolios being sold and hence larger losses for banks, stymieing the bad loan market.

After a slow start due to the patchy state of Italian banks’ loan records and its own complexity, the GACS scheme has been a key contributor to banks’ bad debt sales.

Bad loans are normally sold at a loss and the hit to banks’ capital limits the amount of these assets lenders can offload.

The guarantee wraps the least risky notes in bad loan securitization issues, reducing the overall financing cost of the transaction, helping banks achieve a better price.

Italian banks had cut their pile of impaired debt to 264 billion euros by the end of last year, according to consultancy PwC.

Bailed-out Monte dei Paschi (BMPS.MI) has tapped the GACS scheme in a record 24 billion euro bad loan securitization. UniCredit (CRDI.MI), Creval (PCVI.MI), Carige (CRGI.MI) are among other banks that have used the guarantee.

($1 = 0.8687 euros)

Reporting by Valentina Za; Editing by Kirsten Donovan

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