"I never expected to see Italy beat the Springboks," admitted the 60-year-old, who coached the team between 1997 and 2000 and also guided the Azzurri for four years.
"Many of our best players are being lured overseas, especially to England, France and Japan, by much higher salaries than they can earn at home.
"It used to be that South Africans went abroad in the twilight of their careers to bolster income. Now they are leaving the country in their prime."
While salaries have never been publicly disclosed, AFP understands that many foreign-based South Africans earn up to five times more than those playing in the republic.
"South African rugby is in a low, depressing, terrible place," admitted Mallett, now an analyst for Johannesburg-based TV channel SuperSport, after the defeat in Florence.
It was the first loss suffered by two-time world champions South Africa in 13 Tests against Italy, who they overwhelmed 101-0 in Durban 17 seasons ago.
South Africa have lost seven of 11 Tests this year, equalling their record for the most defeats in a season since returning to international rugby in 1992 from apartheid-induced isolation.
"In 2007 we were world champions and two years later won twice in New Zealand. Seven, eight, nine players from those teams would have been World XV candidates," said Mallett.
"Not one current Springbok would be a contender for a World XV place. It is a team that has no confidence.
"It would be easy to blame the coach (Allister Coetzee) or the captain (Adriaan Strauss), but the problems run deeper than that.
"We need to choose our best players and make sure they are handled by the best coaches."
Mallett pointed a finger at some senior players, saying "they have let the team down, sometimes failing to perform basic skills like catching a lofted kick.
"Springbok attacks are too simplistic - all you need do to stop them is be brave. We still believe we can kick and tackle our way to victories.
"Rugby has evolved, but the Springboks have not. There is a need for a massive mindset change," stressed Mallett.
"Lions were the only South African franchise to impress in Super Rugby this year, reaching the final, and that was a clear indication that trouble lay ahead.
"Stormers were hammered at home in the quarter-finals and the Sharks, Bulls and Cheetahs did not even make the knockout phase."
South Africa complete a three-Test tour next Saturday against Wales in Cardiff.
Original source: Player exodus hurting battered Boks - Mallett