When the CEO of Unicredit Group Mr Mustier stated that FINO stood for “Failure Is Not An Option”, he was staking his reputation on the full completion of the deal.

But its chance of success hangs by a thread.

The deal, by the way, is aimed at spinning off the worst of Unicredit SpA’s Non-Performing Loans (“NPLs”) – drawn from its book of “Bad Exposures” – and packaging them into bonds that can be re-financed at the European Central Bank, or – in plainspeak – making a silk purse out of a sow’s ear.

The bonds need to be pubicly rated in order to be eligible for ECB finance and last week the first of the four oracles, DBRS, spoke. The bond issuer is a typical securitisation vehicle company called “Fino 1 Securitisation s.r.l.”. It has issued three classes of notes and the key rating is the one on the Class A notes.

DBRS has rated the Class A notes as BBB, two notches below the level equivalent to Single A in the S&P system that is necessary for the notes to be admitted to the European Central Bank’s list of eligible collateral.

Mr Mustier, though, has three more darts in his hand in this variant on a four-dart finish: he now has to step up to the oche and hit a Single A or better on two of S&P themselves, Moodys and Fitch. With two rating agencies assigning their equivalent of Single A or better, the bonds can be admitted to the list (assuming that the ECB can get over the issue of the valuation of the Non-Performing Loans themselves – see below for more on that).

Until then Unicredit itself is the owner of the Class A notes, issued to them in exchange for selling the portfolio of NPLs that sits behind the issue.

In fact, because Unicredit is a 49% shareholder in “Fino 1 Securitisation s.r.l.”, it will also be owning:

  1. 49% of the Class B notes of €29.64 million = €14.52 million;
  2. 49% of the Class C notes of €40 million = €19.6 million;
  3. €684.1 million of notes in all.

The NPLs behind the structure amount to around €5.3 billion in nominal value, so the total of Class A, Class B and Class C notes issued against this portfolio – at €720 million – equate to 13.5% of the nominal, and the portion of the notes that Unicredit owns – €684.1 million – is 12.90% of the nominal. Unicredit wrote the value of the entire FINO portfolio down to 12.96% of nominal in its books in late 2016, so we can posit that Unicredit sold the respective portion of the FINO NPLs that sits behind “Fino 1 Securitisation s.r.l.” at exactly the value to which it had written them down in its own accounts. Unicredit thus avoided the embarrassment of putting a further provision through line 130.a in its P&L account, over and above the provision of €3.6 billion for writing down the FINO portfolio that was disclosed in the Prospectus for the rights issue.

Unicredit has transferred a total nominal of Non-Performing Loans of over €17 billion under the FINO project, but what is new is that there is not just one FINO-related securitisation vehicle company but more. By launching an issue from “Fino 1 Securitisation s.r.l.” and backing it with €5.3 billion of NPLs, Unicredit signals that there could be “Fino 2 Securitisation s.r.l.” and possibly “Fino 3 Securitisation s.r.l.” and so on, until all of the €17 billion nominal of NPLs earmarked to the FINO project have gone through the process.

But FINO will not be a sucess until all of the Class A notes of all FINO securitisation issuers are on the ECB list of eligible collateral and re-financed by the National Central Banks in the Eurosystem. The aggregate of Class A notes should total over €2.1 billion if they are issued in the same proportion (12.26%) to the nominal value of NPLs backing them as the Class A notes do compared to the NPLs of €5.3 billion backing this first transaction. The Class B and Class C notes are then the make-weight that bring the total of notes issued to Unicredit to the same value to which it wrote the FINO portfolio down in its 2016 accounts: €2.2 billion or 12.96% of nominal.

Until the point of success is reached, all Unicredit has achieved is to move €2.2 billion from line 70 “Loans and receivables with customers” and inserted it into line 20 “Financial assets held for trading” in its accounts. The Class A notes at least will already be eligible, with a haircut, to count into the bank’s High-Quality Liquid Assets for the purposes of its compliance with Basel III Liquidity Coverage Ratio and Net Stable Funding Ratio. That is quite a neat trick in itself, to convert a chunk of “Bad Exposure” into a High-Quality Liquid Asset just by a sale and buy-back.

But it is not enough for Unicredit, because it does not represent full completion of the FINO project. A failure to fully complete must put a question mark against the transparency of the 2017 rights issue, as well as put in doubt the survival of Mr Mustier himself, since he has staked his reputation on FINO.

Another tricky issue is what will be the quality of the NPLs behind “Fino 2 Securitisation s.r.l.” and possibly “Fino 3 Securitisation s.r.l.” and so on, compared to the ones behind the first issue. Surely it is in the nature of things, to use a cricketing analogy, to send the best batsmen in first, or at least the most solid ones if not the most exciting. If Unicredit has done this and the best batsmen have been returned to the pavilion by DBRS notching up no more than a BBB with the scorers, it does not bode well for the middle order – “Fino 2 Securitisation s.r.l.” – or the tailenders – “Fino 3 Securitisation s.r.l.”.

FINO, in common with all of the so-called “market-based recapitalisations” of Italian banks, is an example of trying to make a silk purse out of a sow’s ear. The FINO portfolio is not a homogenous portfolio of NPLs: “Fino 1 Securitisation s.r.l.” may have been backed by ears of the top breed Gloucester Old Spot, but when we get down to “Fino 3 Securitisation s.r.l.” we could be talking the Gadarene swine.

The next rating handed down by an agency on the Class A notes of “Fino 1 Securitisation s.r.l.” must be an A from S&P, an A2 from Moodys or an A from Fitch, and then another must quickly come up with the same thing – or FINO will have failed.

The chances of success after DBRS came up with only BBB are slim: DBRS has up to now been the agency that has shown the greatest tolerance of these structures, and whatever agencies say about their being completely independent of one another, DBRS has set a benchmark and another agency would have to come up with solid reasons for rating the notes two rungs better.

The ECB and the Eurosystem members (apart from the Banca d’Italia) will be hoping they don’t: the ECB to spare themselves the embarrassment of deciding whether to overlook the price at which the NPLs were sold by Unicredit and what payments supported that price, and the other Eurosystem members so they do not have to refinance this pile of junk. The FINO NPLs were taken from the very lowest category in Unicredit’s NPLs – having travelled down from “Past due” to “Non-Performing and Past Due” to “Unlikely to Pay” and then to “Bad Exposures” (= highly likely not to pay) and only stopped dropping when they had reached the bottom of the barrel.

All the way along Unicredit’s provisioning of the loans was inadequate, even the write-down to 12.96% of nominal in Q4 2016, it now appears.

According to a Bloombergs report on 30/10/17,  the ECB is investigating the price at which Unicredit sold the FINO NPLs to the securitisation companies on the question of whether “the already low price at which the loans were sold…was inflated by fees the bank is paying to the buyers to manage the loans”.

What this infers is that the co-investors, who own 51% of the securitisation vehicle company, did not value the FINO portfolio as a whole at 12.96% of nominal but lower. In order to bridge the gap – and let’s posit that the valuation was 8% of nominal – Unicredit appears to have been willing to pay some sort of inducement fee separately, to induce the securitisation vehicle company to issue it with notes to the value of 12.96% of the NPLs, in a form of round-trip.

Unicredit would then have to pay out 4.96% of nominal as a commission to the securitisation vehicle company, probably through line 50 “Fees and commission expense” in its P&L account, so that the securitisation vehicle company has paid 8% net for the NPLs, which is today’s valuation.

Unicredit thus holds notes with a nominal value of 12.90% of the nominal value of the “Fino 1 Securitisation s.r.l.” portfolio or €684.1 million, and the co-investor is holding 51% of the Class B and Class C notes, making up total financing of “Fino 1 Securitisation s.r.l.” of €719.64 million, or 13.58% of the nominal value of the NPLs.

If the underlying valuation of the NPLs is 8% of nominal but the notes are for 13.58% of nominal, the value of the notes has been artifically inflated: the assets behind the notes do not support that valuation. If that is the case then Unicredit is:

  • over-valuing the notes in its own books;
  • over-stating its compliance with Basel III Liquidity Coverage Ratio and Net Stable Funding Ratio.

The ECB will not want to be forced into a position of valuing the Class A notes at near to par as collateral for loans by Eurosystem members to Unicredit. If it does put the Class A notes onto its list of eligible collateral, the Eurosystem members will then be obliged to advance funds against them at face value less a very small haircut. The haircut will be all the smaller because these are floating rate notes and not fixed interest ones, so the haircut component accounting for absolute interest rate risk falls away.

Eurosystem members would be compelled to advance funds to Unicredit of say €649 million (Class A notes’ face value less a tiny haircut) against a portfolio of NPLs of nominal €5.3 billion, that the co-investors in the securitisation vehicle company had valued at 8% of €5.3 billion – €424 million. The loans drawn from the Eurosystem by Unicredit would then exceed the valuation of the underlying assets by €225 million (€649 million minus €424 million).

It is scandalous that Unicredit has been allowed to get away with not writing the FINO NPLs down to zero, and can even talk about NPLs as some kind of asset class in their own right. Still more scandalous if it turns out that it has paid commissions to the securitisation vehicle companies in order to both artificially raise the price at which it sold the FINO NPLs, and to create notes that are over-valued in its own accounts, that overstate its compliance with regulatory ratios, and that inflate the notes’ value as ECB collateral in order to gain an excessive amount of loan financing from the Eurosystem members.