The Fate Of The Euro Hinges On Italy. Italy's Looking Iffy

By Edward I. Altman, Max L. Heine Professor of Finance, NYU Stern School of Business, Director of Debt and Credit Markets, NYU Salomon Center


One year ago, I wrote about the European debt crisis and predicted that Italy would be either the hero or villain of the Euro. I felt then, as I do now, that the escalation of the crisis would come down to whether one of the key Southern European countries would be able to survive, without a bailout, the onslaught of a capital market “attack.” Based on the inherent strengths of its fundamental competitive and wealth attributes, I concluded that Italy would be the “fulcrum country,” with a 70% chance to emerge successfully, enabling the Euro itself to survive. Since the end of 2010, unfortunately, Italy’s fundamentals have deteriorated dramatically, its economy is in a double-dip recession, unemployment is over 10%, and even top European politicians are now saying that the Euro’s survival is at the critical stage. My current assessment is that Italy’s, and also the Euro’s, solvency is at best a 50-50 probability, notwithstanding the announced change in EU policy toward pumping  €130 billion of fiscal stimuli into the most vulnerable European nations and steps toward a financial and political union.
My increased pessimism is based on our “bottom-up” approach toward assessing the health of any sovereign. Recently, Professor Herbert Rijken of the Free University of Amsterdam and I began suggesting that financial and political analysts should not focus solely on the traditional macroeconomic metrics like Debt/GDP or Deficits/GDP, but also to monitor the health of the sovereign based on the condition of its private sector – both its non-financial corporate sector and its privately owned banks. After all, if the corporate sector is healthy, it can pay more taxes from profits and hire more workers, as well as provide vital new investments. On the other hand, if a significant proportion of a sovereign’s private sector is on the verge of financial distress and bankruptcy, or needs increased capital itself, it cannot hope to contribute much, particularly if companies are asked to increase tax payments.

Figure 1: Financial Health of the Corporate, Non-Financial Sector: Selected European Countries and U.S.A. in 2008 – 2011, Z-Metrics Median PD Estimates. *Since the Z-Metrics Model is not practically available for most analysts, we could substitute the Z”-Score method (available from altmanZscoreplus.com). Sources: RiskMetrics Group (MSCI), Markit, Compustat.

We developed an index of individual firm probability of default, based on an updated version of my somewhat ancient, but still relevant and accurate Z-Score Approach (now available in a new App (called “AltmanZscoreplus.com”). We then observed the median (50th percentile) and 75th percentile firm’s probability of default (PD) for the non-financial, listed-firm, population in each of nine European countries, as well as in the U.S.A., for the years 2008-2010 (see Figure 1). The results were extremely revealing with the highest risk countries, Greece (16.7%) and Portugal (16.6%), followed by Italy (11.3%), and Spain (8.6%), showing the most troubling corporate PDs as of year-end 2008, even before the financial world showed much concern with these sovereigns and before the Greek PM informed the world in October 2009, that its budget deficit was 12.7% (double the previous estimate).

Figure 2: Financial Health of the Corporate, Non-Financial Sector: Selected European Countries and U.S.A. in 2008 – 2011, Z-Metrics 75th Percentile PD Estimates. *Since the Z-Metrics Model is not practically available for most analysts, we could substitute the Z”-Score method available from altmanZscoreplus.com). Sources: RiskMetrics Group (MSCI), Markit, Compustat.

Figure 3: Five Year Implied Probabilities of Default (PD) from Capital Market CDS Spreads*, Jan. 2009 – June 25, 2012. *Assuming a 40% recovery rate (R); based on the median CDS spread (s). PD Computed as 1-e (-5*s/(1-R)). Source: Bloomberg

Our updated bottom-up results through the end of 2011 are startling and highly indicative of the profound deterioration of all European nations in just one year, with Italy and France “leading the way” down. For example, the 75^th percentile listed non-financial company in Italy (e.g., indicative of the 25% most risky companies), as of year-end 2010, had a PD of 14.1% over a five-year horizon (note that 25% of the private sector’s PDs was greater than 14.1%). In just one year, that figure spiked to 26.4%, (second only in Europe to Greece’s astounding 50.5%), a deterioration of 87% (see Figure 2), the largest drop in Europe. It is worth noting that these are the largest, and arguably the most solvent Italian enterprises. A weakened banking sector, with its own profitability and capital challenges, will be hard pressed to support such a problematic corporate sector. While Italy’s global competitiveness is far stronger than that of Greece, Portugal and Spain, the problem is that unlike these smaller vulnerable countries, Italy is “too big to save.” Thus, while we focus on the private sector, the world’s markets, as well as European politicians, are traumatized by Italy’s escalating cost of new debt financing that now exceeds the thought to be unsustainable 6.0% level for 10-year bonds. Furthermore, the implied 5-year PD from CDS spreads for Italy is above 35% and close to 40% for Spain, (Figure 3). No wonder Italy’s PM, Mario Monti, has conceded that the survival of the Euro is now at stake. His country will be the last bulwark before the possible bursting of the “Euro-dyke” that EU leaders are so desperately trying to keep intact – - with good reason.
A surprising recent finding in our sovereign risk assessment is that the country with the second largest percentage deterioration in the risk profile of its private, non-financial in sector in 2011 is France, whose 75^th percentile-firm has a PD of 14.8%, up from 8.5% one year ago – - a 74% slide! Among the countries we analyzed in 2011, the Netherlands’s 75^th percentile was the lowest (8.7%). Incidentally, the 75% percentile U.S. company’s PD is slightly higher than the Dutch at 11.7% – - a respectable figure similar to that of Germany. One can wonder if France, with its enormously leveraged and problematic banking system and with an increasingly vulnerable private sector, is indeed worthy of its AA+ (S&P) and AAA (Fitch), Aaa (Moody’s) ratings. I certainly question those lofty assessments. The same could be said for Italy’s A₃/A- rating.
So, will Italy make it? Will the Euro survive? We should know the answer within 12 months, perhaps sooner, but the odds against this happy ending are increasing with each piece of bad news about Italy’s economy and its fundamental components.

http://www.forbes.com/sites/beltway/2012/06/29/the-fate-of-the-euro-hinges-on-italy-italys-looking-iffy/