THE NEXT FINANCIAL CRISIS

On the afternoon of Nov. 28, Luigino D'Angelo, a retired electricity company engineer, sat in front of his computer, calmly wrote a suicide note and printed it out. When his wife, Lidia, stepped outside to water the plants, Mr. D'Angelo, who was 68, wrapped a cord around his neck and hanged himself from the balustrade of the stairs leading to the cellar.

His death not only shattered Ms. D'Angelo's life; it made him a symbol of the banking disaster that has gripped Italy and triggered a government crisis whose repercussions could lead to the collapse of the centre-left government of Prime Minister Matteo Renzi as early as this autumn. According to Mr. D'Angelo's note, he would kill himself because the government-directed rescue of his failing bank, Banca Popolare dell'Etruria, a small Tuscan lender, had wiped out his life savings of €110,000 (about $160,000).

Italy is cluttered with ailing banks, big and small, that are stuffed with non-performing loans worth an astounding 18 per cent of Italian gross domestic product – among the highest in Europe and the world – the result of a long, deep recession that has bankrupted tens of thousands of businesses. Mr. Renzi wants to use public money to bail out the lenders teetering on the edge of the cliff, but the European Union's new bailout rules mean that bank investors – mostly the holders of the banks' senior and junior debt – have to take a hit before a taxpayer-funded capital injection can even be considered.

If Mr. Renzi does not get his way, the hundreds of thousands of Italian families who loaded up on bank debt would face financial ruin as the Italian banking system is restructured.

Were that to happen, Mr. Renzi's government would probably fall, leading to a fresh political and economic crisis that could plunge Italy, the euro zone's third-largest economy, back into recession and invigorate the anti-European Union and anti-euro parties that are gaining momentum in Italy and elsewhere on the continent.

Many economists and political analysts consider the ailing Italian banking system a bigger threat to the EU economy than Brexit – Britain's exit from the EU. Certainly, the Italian banks seem to be the top worry of European Central Bank President Mario Draghi, who has been urging Italy to create a public backstop for the banks' burgeoning portfolio of bad loans.

In a report published on Tuesday, TD Economics said a "banking crisis in Italy would spill over to its major trading partners, jeopardizing the viability of the currency union."

On Friday, as the Italian government was frantically trying to orchestrate a rescue of Italy's third-largest bank, Banca Monte dei Paschi di Siena (MPS), the results of the latest bank stress tests highlighted the generally sorry state of the Italian bank industry, in particular MPS, even if European banks in general had stronger capital buffers than they had a couple of years ago.

MPS was the standout failure in the EU stress tests, which measured the top 51 banks' ability to withstand a theoretical financial crisis. The tests showed the bank's key capital ratio would turn negative by the end of the three-year adverse scenario, indicating the bank would be insolvent. (Among non-Italian banks, Ireland's AIB and Britain's Royal Bank of Scotland also fared poorly).

The situation is so serious that some politicians in Rome wonder whether an Italian bank bailout from the European Stability Mechanism (ESM), the EU's main bailout fund, might surface as an option. This week, as rumours swirled that the ESM had sent an advance team to Rome – the ESM denies it has done so – Daniele Capezzone, a conservative lawmaker who is a member of the Italian parliament's finance commission, used his blog to urge Italy to "resort to the ESM."

'We have lost everything'

On a brutally hot day last week, Ms. D'Angelo, 64, was sitting in the kitchen of her tidy little house – 1980s vintage – on the hill overlooking Civitavecchia, the buzzy, tattered port city about an hour's drive north of Rome. Pictures of her husband decorated the room. A tall, genial-looking man with thinning white hair, he was an avid athlete and owned an expensive Tommasini racing bike.

As her 91-year-old mother Anna prepared soup, Ms. D'Angelo excused herself, disappeared into a back room and emerged with her husband's typed, one-page suicide note.

The note opened by soliciting his "apologies to everyone" and went on to provide a short summary of the financial horror that consumed his life in the months before he chose to end it. In essence, Mr. D'Angelo alleged that he was the victim of a sales campaign that he considered deceptive and fraudulent.

Etruria had sold him subordinated bonds, also known as junior bonds, whose risks, he said, were not explained to him (such bonds rank below senior debt and, in the event of a default or court-sanctioned restructuring, get paid out only after the senior bondholders are paid in full). "We only learned later that they were dangerous," he wrote.

Indeed, when the bank was rescued and recapitalized last November, the subordinated bonds were wiped out. "And that's how the [savings] of my entire life vanished," he said in his note.

Ms. D'Angelo is from Abruzzo, the generally poor, mountainous region due east of Rome. She has no children and tended to the house while her husband worked at Enel, the national electricity utility. Etruria had always been part of their lives. "My father was a client of the bank 50 years ago," she said. "There was never any problem. We had faith in the bank."

In 2013, with interest rates falling, they decided to invest their savings in bank bonds. But Ms. D'Angelo said their primary goal was capital preservation and that they had no intention of gambling on a high-risk product that would pay a high return. By mid-2015, as the media was brimming with stories about rotting banks, notably MPS, they learned to their shock that the bonds could be in danger.

In September, Mr. D'Angelo decided he would sell the bonds. In repeated visits to Etruria's local branch, about two kilometres from their house, he offered to give them up for 70 per cent of their face value. But the bank would not buy them back and no market existed for them. "On Nov. 22, we were in the kitchen for lunch, watching TV," Ms. D'Angelo said. "We saw that Renzi had signed the deal to save four banks. One of them was our bank. At that point, my husband told me, 'We have lost everything.' "

He killed himself six days later.

The rescue of Etruria, laden with more than €300-million of bad debts, and the other three small lenders was done under the auspices of the EU's Bank Recovery and Resolution Directive (BRRD), which had been incorporated into Italian law only a few days earlier. To prevent exposing taxpayers to the full brunt of a bank bailout, the directive insists that no public capital can be pumped into the failing bank until 8 per cent of the bank's total liabilities are "bailed-in," that is, eliminated.

As a result, Etruria's subordinated bonds went up in smoke. The tragedy is that Italian retail investors were encouraged to buy the bonds; until 2011, they even came with preferential tax treatment. Bruegel, the Brussels think tank, calculated that about a third of all Italian bank debt is held by households, far higher than the EU average.

A new report by the International Monetary Fund (IMF) confirms that Italian retail investors bought subordinated and senior bank debt with abandon in recent years. By mid-2015, retail investors held about €200-billion of senior bank debt, equivalent to about one-third of all senior bank debt, and €31-billion of subordinated bank debt, almost half of the total. All that debt is potentially at risk if more bank bail-ins are required, which seems inevitable.

"The fact that banks were allowed to sell their own risky debt to households as a savings product for so long is disturbing, as is the fact that no one in Italy appears to have taken any accountability yet for this policy failure," Bruegel's Nicholas Véron said in a July note.

A standout dud

Matteo Renzi was not supposed to inherit a banking crisis, certainly not one that could sink his short career, threaten the fragile EU recovery and potentially deliver an existential threat to the euro.

Any bank crisis in Europe is, by definition, potentially more serious that one in North America because banks play a more significant role in the financing of the economy. In the United States, the capital markets finance more than two-thirds of mortgage and corporate debt; banks provide the rest. In Europe, banks provide more than 80 per cent of the lending to the real economy. European companies rarely bother with initial public offerings, relying instead on carefully nurtured bank relationships to fund growth.

The financial crisis in 2008, highlighted by the collapse of Lehman Brothers, sent shock waves through the entire European banking sector. The damage has yet to be fully repaired. Once mighty Deutsche Bank has yet to recover and trades at a mere one-quarter of book value. Britain's June 23 vote to leave the EU walloped the banks again.

Of course, Italian banks were damaged in the financial crisis. But, unlike, say, the British banks, a few of which had to be nationalized, the Italian lenders were left standing. They had not loaded up on incomprehensible financial instruments, such as mortgage-based collateralized debt obligations, that would prove toxic during the crisis. Equally, Italian banks were never exposed to a property bubble of the size that pushed Ireland into a sovereign bailout in 2010 and triggered a Spanish bank bailout, financed by the ESM, two years later.

Silvio Berlusconi, the party boy billionaire who was then prime minister, was so proud of the apparent resilience of the Italian banks that he essentially denied that Italy was even in recession. In November, 2011, he told the media at the Group of 20 summit that "The life in Italy is a life of a wealthy country. Consumptions haven't diminished, it's hard to find seats on airplanes, our restaurants are full of people."

His laughable exercise in denial cost him his political career only three weeks later, when he was ousted and replaced by technocrat prime minister Mario Monti, who served until 2013.

In truth, the Italian banks were falling apart under Mr. Berlusconi's watch because the Italian economy, by then in a double-dip recession, was a mess, pushing non-performing loan portfolios to ugly levels. Bankruptcy rates were soaring, entire industries were hollowed out as factory orders plummeted and struggling banks choked off loans to the real economy. Plummeting interest rates damaged the banks' profitability by narrowing loan spreads.

The lack of a Europe-wide response to the banking crisis did not help. Nicholas Spiro, a partner at London's Lauressa Advisory, notes that the EU lacked the equivalent of TARP, the $700-billion (U.S.) Troubled Asset Relief Program, which was launched by the U.S. government after the Lehman Brothers collapse to buy troubled loans and securities and shore up the banks' capital. "[German Chancellor] Angela Merkel did not want to foot the bill for Southern Europe's profligacy," he said. "The lack of a TARP equivalent is the most conspicuous failure of political and economic governance of the euro area."

But Italy was its own worst enemy. Gross domestic product and productivity growth have been negligible since the country adopted the euro in the late 1990s. Widespread corruption, a sclerotic judiciary, a bloated bureaucracy and perennial political chaos have ensured Italy's underperformance in recent decades. Since 2008, the country has lost more than a quarter of its manufacturing base. Its debt-to-GDP, at 133 per cent, is second only to Greece in Europe and gives it no fiscal breathing room.

The IMF predicts that Italy, whose economy is still bigger than Canada's, will not return to its precrisis GDP peak until 2025. Unemployment in June rose slightly to 11.6 per cent while youth unemployment was a crushing 36.5 per cent. No surprise, then, that non-performing bank loans have soared. In 2008, they were equivalent to 5 per cent of GDP and have risen every year since, hitting 18 per cent in 2015. The figure in Germany is 2 per cent, in France, 4 per cent.

At last count, the tally of the non-performing loans had reached €360-billion, roughly equal to the GDP of Austria. The good news, such as it is, is that the level appears to have stabilized and the provisions already booked have reduced their net value to €197-billion. But that's still high by any measure.

The standout dud is MPS, founded in the Tuscan city of Siena in 1472, when Leonardo da Vinci was a young man and Christopher Columbus had yet to discover America. MPS's sour loans stood at €46.9-billion last year, or 35 per cent of all lending, and its shares trade at about a tenth of book value.

Bailed out twice since the start of the financial crisis, the once-mighty bank is now a penny stock, having lost more than 80 per cent of its market value on the Milan bourse in the past year alone. It is now worth less than €1-billion. In 2014, when the European Central Bank conducted comprehensive stress tests of the euro zone banks, MPS was the prominent loser. Eight other Italian banks also came up short, making Italy the region's top danger zone.

The near demise of MPS has emerged as a huge political problem for Mr. Renzi, says Francesco Galietti, chief executive officer of Policy Sonar, a political risk consultancy in Rome. Mr. Renzi, who is 41 and has been prime minister since early 2014, is, in the public's eye, intimately associated with MPS. He is the former mayor of Florence, the capital of Tuscany, and MPS is the most prominent Tuscan bank. It has also been closely associated with Italy's Democratic Party, which is led by Mr. Renzi. "Renzi and Monte dei Paschi are seen as one," Mr. Galietti said. "If the bank gets damaged again, or fails, it will have repercussions for Renzi himself."

Terrible timing

All European eyes are on Mr. Renzi, who is seen as the man who can make or break the Italian banking system, depending on his fix-it strategy. If he succeeds, he will spare Europe a fresh crisis. If he fails, he could plunge the EU into a new one.

Certainly, the timing could not be worse. The EU is dealing with Brexit, a refugee crisis and a string of horrific terrorist attacks in France, Germany and Belgium. Turkey, on the southeastern fringe of the continent and a potential EU member, is in danger of turning into a dictatorship. Unemployment in the EU's southern flank is obscene; Greece is still a wreck, with an unemployment rate of 23 per cent. Populist and nationalist parties, most of them anti-EU, anti euro or both, are on the rise.

The last thing Europe needs or wants to see is one of its major economies felled by a bank disaster. It could be one crisis too many and might immediately lead to Italy's potential withdrawal from the euro. (Italy's main opposition party, the Five Star Movement, is calling for a referendum on the single currency.)

Mr. Renzi is already seeing the banking crisis morph into a political crisis that threatens to destabilize Italy. In his effort to streamline government, he has called a referendum on constitutional reform, which is supposed to happen in October. The idea is to downgrade the powers of the Senate, which currently enjoys perfectly equal power with the Chamber of Deputies. Were that to happen, the law-making process would be greatly simplified.

But Mr. Renzi vowed to resign if he were to lose the referendum, turning it into a popularity contest that could well go against him. If he loses the referendum, Italy could enter a nasty period of political chaos that could stall all economic reform, including banking reform. "He made a big mistake by personalizing the referendum," said a top executive at a big European bank who spoke on condition that he not be named.

Mr. Galietti, the political risk consultant, thinks Mr. Renzi is doomed. "Renzi's narrative is crumbling," he said. "It was all based on growth but there is no economic rebound. The economy is heading into another recession. … If the MPS rescue hurts retail investors, it will undermine confidence in him and the banks."

Mr. Draghi, the ECB president, is obviously worried that the Italian bank mess will sabotage his plans to fix the euro zone economy through a combination of ultralow, even negative, interest rates, endless bank liquidity injections and an €80-billion-a-month quantitative easing program. During his Frankfurt press conference on July 21, he backed a public bailout of Italy's banks "in exceptional circumstances."

While he would not provide details, he was probably not referring to the use of taxpayer funds for a full bailout of MPS, which would contravene EU rules. More likely, he was endorsing a government backstop for the purchase and sale of non-performing loans held by MPS and other banks, no easy task when Italy lacks a functioning market for such loans. What was abundantly clear was that the Italian banks, not Brexit, are his top worry.

In the days leading up to the release of the new bank stress tests, the Italian government was scrambling to sort out the MPS mess in a way that would not blatantly contravene the EU's new bailout rules or destroy Mr. Renzi's chances of winning the referendum by pushing junior bondholders into the slaughterhouse.

By Friday evening, just ahead of the results of the latest European stress tests, it appeared MPS had cobbled together a last-minute rescue. According to various reports, it would see the bank spin off about €10-billion in non-performing loans into a separate entity.

At the same time, a banking team led by Wall Street's JPMorgan and Italy's Mediobanca would underwrite a share issue, its third in recent years, worth €5-billion.

It was not immediately clear whether junior bondholders would be sacrificed. If that were too happen, it would trigger a political backlash that could prove highly damaging to Mr. Renzi.

The MPS rescue may also be too little, too late, to restore the health of the Italian banking system – an exercise in buying time. "You need to restructure the entire banking system," said the banker who did not want to be named. "The banks still have terrible returns on equity. A piecemeal approach won't work."

The banks, he said, need to cut costs drastically. The country probably has twice as many bank companies and bank branches as it needs. Consolidation needs to happen in a hurry and dud loans need to be unloaded. A market for non-performing loans needs to be developed. The ailing economy makes a banking industry restructuring all the more urgent – the banks will not be able to grow themselves out of their problems.

Back in Civitavecchia, Ms. D'Angelo wasn't getting her hopes up that a restitution fund would restore some of the losses suffered by her and her late husband. But she took some consolation in knowing that his suicide rattled the government and the banking system.

"The death of my husband changed everything," she said. "We know now that the banks were sleazy."