Cyprus Bailout: Stupidity, Short-Sightedness, Something Else?

A quick run-down on the impressively stupid handling of the "Cyprus bailout" by the EU.

And, before we go on, we should note that the on-the-ground situation for visitors and tourists is perfectly fine – Cypriots are not prone to rioting and even though the banks are closed, the ATMs still work. We are all at work and things are otherwise proceeding normally.

UPDATED: What do we do now?

First, some background that most people know partially but not completely:

1. The Cyprus sovereign has not been particularly profligate. Debt to GDP as late as last year was in the low 70% range, lower than Germany, etc. While the last Communist government ran unnecessary fiscal deficits, the new government was elected with a more or less ‘austerity’ orientation

2. The issues with the Cyprus sovereign have come from the bailout of the banking system.

The banking sector in Cyprus is being portrayed in the mainstream press as a monstrosity of risky banks for Russian mobsters. I think it is important to put it in context:

(a) Banking assets are about 7.1x GDP relative to the EU average of 3.5x GDP and similar to Ireland and Malta.

Luxembourg, by contrast, where Anglo-Saxon firms do their tax arbitrage has banking assets of 21x GDP. So, Cyprus’s exposure is similar to that of an economy that has large financial services sector, but that still has a real economy too. It is not Luxembourg nor the Cayman Islands nor the Bahamas nor the Channel Islands and so on.

(b) Further to this point, 20B of the 70B of deposits are non-EU (aka Russia/CIS) which, while meaningful (28%), hardly dominate the system

(c) The banks are almost 100% deposit funded (something that regulators across the world have been encouraging because deposits tend to be sticky if you take care of them).

3. Q: So, given all that, why do the banks need a bailout?

A: Primarily due to their exposure to Greece, Cyprus’s neighboring economy, both on the commercial side, but most importantly and most critically because of the Greek Government Bond EU restructuring (this accounts for about 40-50% of the capital needs) which Cyprus signed up for in the spirit of EU / Greek solidarity. It was understood at the time that there would be some protection in exchange for this later on otherwise, Cyprus should have taken a harder line at the time such as ensuring the that Greek branches get covered by the Greek bailout.

4. Not all the banks are in the same condition.

(a) Cyprus has two money-center type banks: Laiki (Popular) Bank and Bank of Cyprus.

(b) Laiki was purchased by a Greek vehicle (Marfin Investment Group) backed by Gulf money. Marfin’s purchase of Laiki took Laiki from being a fairly conservative local bank to being highly exposed to Greece. Laiki is definitely insolvent and needs to be restructured.

(c) Bank of Cyprus has been more conservative vis-a-vis Greece, but still has meaningful exposure. It is conceivable that, given time, Bank of Cyprus could survive.

(d) Beyond the main two banks, there is Hellenic Bank (a much smaller bank with much less Greek exposure), Cyprus Development Bank (no Greek exposure), the Co-ops (no Greek exposure) and the Cyprus subsidiaries of foreign banks (aka, Russian, English, etc banks), also with no Greek exposure.

(e) All the local oriented banks (BoC, Laiki, Hellenic, Coops) have exposure to the local real estate market that went through a bubble during the 2000-2009 period. This exposure however is not short-term and could be resolved over the period of years. It is a problem, not a crisis, and is offset by the fact that the two main banks have quasi-monopolistic earnings power locally. Given the time and some financial represssion (a la the United States) and the local issues would be manageable.

Now, let’s go to the current situation:

5. Three weeks ago, Cyprus elected a pro-EU, pro-Merkel, pro-austerity president (Anastassiades) to replace the anti-EU, anti-Merkel, anti-austerity president it previously had (Christofias). The population recognized the need for austerity and sent to Europe the person it believed would be the most acceptable to the troika.

6. Last Friday, on his first visit to the troika, Anastassiades was ambushed when the troika said to him:“Agree to depositor bail-in as part of the financial package or the ECB will cut off funding to Laiki on Tuesday”causing a surprise collapse of your banking sector.

Unsurprisingly he agreed under that 4am-in-the-morning pressure, though Parliament is now doing its democratic duty and pushing back. In the meantime, the banks are on ‘bank holiday’. The Troika is re-spinning the story, but all you need to do is read the newpaper articles from Saturday and the public statements on Saturday to see that this was the case.

7. Now, it is important to note that the Tuesday deadline is completely arbitrary. Cyprus applied for a bailout nine months ago and has a major bond payment this summer, so the only reason for the ‘rush’ was to ambush him on his first week on the job so to speak and force passage of the bill through Parliament before markets open. In the spirit of this ambush, Russia, which has been asked to restructure its sovereign loan to Cyprus, and has been told that they would be a part of any bailout found out about the approach in the newspapers which did not improve their mood.

The Important Stuff:

Now, let’s get to the meat of the situation. Most of the international analysis of the ‘bail-in’ has been, quite frankly,very sloppy, along the lines of ‘depositor bail-ins are not ideal, but Cyprus has naughty Russian money-launderers so serves them right – it is only fair that these fatcats pay for the bill’.

While superficially pleasing, this is misguided along half a dozen lines.

8. You never, ever, ever, hit insured depositors.

That damage is done and it is EU-wide. There is now precedent that in the EU, deposit insurance can be end-runned via a ‘wealth tax on the deposits you had in the bank at 4:59pm on Friday afternoon’. While this may be legally not a violation of deposit insurance (aka the bank did not fail, the government grabbed your money), it is a violation of the spirit and will be challenged both under the Cypriot constitution and the European Court of Human Rights.

It is also completely clear that this was not something that the Cyprus government invented – it was forced on them by the Troika. As late as the prior week, both the President and Minister of Finance said: “No depositor haircuts — this is the stupidest idea in the world for the EU”

Whether or not there is a bank run tomorrow in Spain, the system damage has been done — look for funding cost to rise for any risky EU bank next time there is a hint of a crisis. The funding costs will be orders of multiples higher than any ‘savings’ here.

9. You should basically never hit non-insured depositors either. For all its free market capitalism, the US extended $13T of guarantees to things like money-market funds to avoid outcomes like this. But in the EU, they are willing to risk lack of trust in the banks over 5B euros.

10. There is nothing resembling a proper order of default here. As far as I can tell, people who have not been wiped out yet include: bank shareholders, bank bond holders, sovereign bondholders.

The rationale, broadly speaking, of why they have not been hit is “It is hard and they might sue us” as if restructuring and insolvency was otherwise a dinner party or we might only save 1-2B that way (as if that is not meaningful in the context of a 5B haircut…)

11. What is even more absurd is that this is not a bail-in of Depositors of Bank A to rescue Bank A, but a bail-in of Depositors of Banks A-Z to rescue Depositors of Bank A (Laiki), B (Bank of Cyprus) and C (maybe some small amounts to the others).

This is one of the reasons that the Russians are howling mad. There are 3B dollars of Russian money in a subsidiary of VTB in Cyprus, a perfectly solvent Russian bank. As far as I can tell, they will be haircut in order to bail out Laiki, a bank that they never deposited money in. On the contrary, the depositors in Laiki’s branches in Greece (aka a totally insolvent bank in a much more insolvent sovereign) will not be haircut.

There is no conceivable creditor prioritization in which this makes sense nor does it teach you anything about moral hazard or fairness. In fact, the only thing it might teach you is: “only put deposits in countries that control their Central Bank” because there is no logic or analysis that could have predictedex antethat a depositor in VTB-Cyprus was more likely to be haircut than a depositor in Laiki-Greece (the latter being 100x more risky than the former).

12. We should also address the “Money Laundering” point. There might be some true money laundering in Cyprus just like there is at dozens of Western banks (HSBC, Standard Chartered, and so on).

There are also legitimate tax reasons for investment in Russia to be routed through Cyprus (BP Russia is also a Cyprus company for example) for well-known and transparent tax treaty reasons, no different than Ireland, Luxembourg, Netherlands, Bahamas, Delaware, Nevada and so on. Someday the whole world financial system might be restructured so there is no tax arbitrage, but that day is not today and why the EU is so “concerned” on Putin’s behalf about whether or not Russian companies are tax-arbing their offshore operations is beyond me.

When the EU figures out how to prevent Google, Apple, Starbucks and friends from operating in their countries and routing all the earnings tax free to the Caymens through a double-Irish Dutch sandwich, then perhaps they can help Putin out with his tax collection work. In any case, Putin certainly does not seem to appreciate the ‘assistance’ here.

Germany is having a completely surreal domestic election discussion about not bailing out wealthy Russians as if this was the key issue at play here or even an issue at all. Put Laiki in resolution and treat it like a normal bank bankruptcy and see who wants to bail it out – you might be very surprised to see that the Russians do, in fact, want to buy it themselves.. In any case, it certainly does not suggest that we should blindly attack depositors in Cyprus banks whose only ‘crime’ using the same banks as people who may or may not have over-optimized their Russian tax bill any more than you should haircut a retail HSBC customer because HSBC facilitated Mexican drug cartel money.

13. “Large” Account holders:

The large account holders (large being defined as above 100K) are not just fat-cat hedge funds (as if 100K makes you a fat-cat) but the operating accounts of basically every business of size in Cyprus.

BoC and Laiki are the whole money center system of Cyprus and basically you cannot transact business in Cyprus if you are of any size and avoid them.

So, the chaos that is going to emerge when checking accounts, payroll accounts, escrow accounts, pensions, trusts, payments-in-transit and so on are arbitrarily haircut is going to be massive – both in disrupted business operations and small business bankruptcies, but also in thousands of legal disputes.

14. Even despite all the arbitrariness above, at least it solves the problem right???

Absolutely not. You will haircut 10% of deposits on day 1 to make up a capital shortfall and promptly watch 30% of the rest of the deposits flee the country, leading to a much bigger capital hole that Europe will have to fill.

In addition, this will severely cramp Cyprus’s main economic driver the last 2 years (selling real estate, tourism and accounting services to Russians) so any concept that it will make the debt “more sustainable” comes from a lunatic place in financial modeling. Cyprus is a 78% services-based economy. So, if you assume that GDP growth is exactly the same before and after you confiscate the assets of your clients, well, I have a solvent Cypriot bank to sell to you…

This is so obviously risky, that the more paranoid commentators believe it is a deliberate plan by Germany to end up as a multi-deca-billion creditor to Cyprus to which the pledging its oil and gas reserves is the only solution. I don’t think this is the case, but boy it is getting hard to believe that they are this short-sighted.

15. We are not suggesting that Cyprus should not feel austerity. If you want to do a wealth tax, then pass a wealth tax, calculate it properly (on wealth, not on liquidity on a given day) and collect it. Or issue subordinate government bonds tied to gas revenue to the local population. And restructure everyone below on the priority chain. And ask Russia to contribute to the bail-out as part of protecting its depositors. Or do a proper workout of Laiki (it is much easier to make the case to the Russians that depositors in Laiki should get haircut given that its financial insolvency has been common market knowledge for a while). And so on.

But don’t arbitrarily, in the dark of night, out of the sight of democratic processes, try to make a grab into the whole banking sector. It makes a mockery of rule of law and the Eurozone.