Thursday, March 21, 2013

Based on the facts alone, Cyprus is not Lehman... unless everyone believes that it is.

Greek Islands have a history of hiding monsters in labyrinths: first minotaurs in mazes, now creditors in balance sheets. 

In trying to explain the world, particularly the European world, I often find myself drawn to the works of Alan Furst. In his novel, Red Gold one of his characters is trying to explain why something that seems obvious may not be: "It should, logically it should. But the world doesn't run on logic, it runs on the seven deadly sins and the weather." This is how I feel about the question of whether Cyprus is a catalyst for the reignition of the Euozone crisis or not.

On Monday I wrote that Cyprus was not a big deal, that because of the unique scope and purpose of the Cypriot financial system the decision to require the, largely non-EU, depositors to contribute to the rescue of the financial system was indeed a one off and that this treatment could not be generalized to the depositors in Spain and Italy. Initially the markets seemed to agree with me and during the day on Monday the markets made back all their losses from Sunday night and monday morning.

But, with the typical Mediterranean flair for the dramatic, the Cypriots decided not to depart center stage of the Eurozone financial crisis. No, no and they really wanted their 15 minutes of fame. No more playing second fiddle to Greece or red-headed stepchild to Turkey. This is their moment to shine. So, rather than knuckling under to the Germans and their troika henchmen and henchwomen they sent the bill authorizing the depositor levy down in flames. I'm sure that felt awesome... for about fifteen minutes.

And that's because while it's one thing to tell the Germans and their henchpersons that you refuse to be a party to their nefarious scheme to raise the 15.6 billion Euros necessary to stave off the collapse of the Cypriot financial system it is another thing entirely to raise 15.6 billion Euros all by your lonesome, or even the 5.6 billion you need to unlock the troika 10. Especially if the total value of all the goods and services produced in your economy is only 18 billion Euros per year, and your government only takes in 7.4 billion Euros per year of which it has already committed to spend 8.2 billion Euros meaning it already has to borrow 800 million Euros just to stay in business. Add to this the fact that the government is already in debt to the tune of 14.4 billion Euros. Then ask yourself, given all the excitement in Greece last year, what are the chances that someone is going to lend them another 6 billion EUR so that they can rescue their depositors? By Monday? I feel pretty comfortable answering that one: zero.

Still, they need the money and I think it makes some sense to discuss the how and the why of that. As a person I do not like AT ALL has nonetheless correctly pointed out, Cyprus has a variety of problems. First of all, as mentioned it has a relatively high debt to GDP ratio of 80% and an annual budget deficit of 4% meaning the finances of the state are a bit complicated. Second, as mentioned in my previous blog post, that has a banking system about six times the size of it's economy owing to the fact that it serves as a banking center for Russian companies which are domiciled there on account of the tax treaty with Russia.

It is important to keep in mind what I mean by this. I do not mean to say that this is some kind of illicit haven, the vast majority of the Russia related financial activity is simply to take advantage of the fact that Cyprus has a tax advantaged status within Russia, is withing the Eurozone, and has a robust rule of law. The way in which the banks in Cyprus are related to Russia is not even that they primarily lend to Russia, though they do, but rather that they provide banking services to the many many Russian companies and special purpose entities which are incorporated there. For example Mark Kurtser, is a Russian doctor whose medical company is incorporated in Cyprus, listed on the London Stock Exchange, and does all it's business in Russia. When it needs to do business in Cyprus, it has a bank account there for the purpose.

So simply because the economy of Russia is so large the businesses which do business in Russia but are incorporated in Cyprus have a lot of need for banking services and there are two important implications of that. First of all is that when you are looking at the official records of the Cypriot banking system a lot of what appears to be a Eurozone deposit is in fact a Russian deposit. Dr. Kurtsers company is an EU entity incorporated in Cyprus doing business in Russia. For regulatory purposes, it's accounts are counted among those of EU residents. So when the EU officials are trying to figure out who is who among the depositors in these banks, it's not so easy to do and is probably why they came up with the broad levy in the first place.

The other implication of this is that since most of what the Russian entities in Cyprus need the banks to do in Cyprus is simple cash management the Cypriot banks have a lot of deposits and therefore haven't really needed to issue other forms of capital and so in the event of an insolvency there isn't much of a capital cushion before you hit the depositors. Have a look at the balance sheet of the Cypriot banking system as a whole . You can see that there are 126 billion EUR in assets. Of those, deposits of Euro area residents (which includes locally incorporated Russian entities) are 72 billion, or 57% of assets and external liabilites, that is deposits that are from outside the Eurozone are 34.7 billion or 27% of assets so 84% of the balance sheet is deposits. To give you some perspective, JP Morgan funds only 49% of its balance sheet with deposits.

So here we have situation in which the entire banking system has only 1.7 billion Euros of bonds outstanding. While there is an item on the balance sheet that says the capital and reserves of the banking system are 15 billion EUR I think the fact that the market cap of the Bank of Cyprus, the largest in the country with a 38 billion balance sheet, has a market cap of 371 Million EUR I think we can say that the equity part of the capital structure is 1 billion EUR tops. So we have 1.7 billion in debt, 1 billion in equity and a 120 billion balance sheet. So in the event that asset prices drop 2% the entire non-depositor capital structure is wiped out. This is why the EU/IMF/ECB demanded that the depositors be part of the mix: there isn't anyone else.

And that includes the Cypriot state. We don't know how big the hole in the banking balance sheet is but given the fact that a 15.6 billion number has been discussed we can assume that it is at least that much and is probably more. Let's call it 20 billion. Now let's imagine that the Cypriot state decides to nationalize the banking system. They step in wipe out the stockholders and the bondholders, they're still in waaay over their heads.  They take over assets worth 100 billion (120-20) but owe the depositors 117.3 billion, or they're 17.3 billion in the hole. So the simple act of nationalizing the banks cannot be done without clipping the depositors for more than they would have lost in the levy. That vote isn't looking so smart now is it?

Thus when the Cypriot parliament, themselves in the hole for 14 billion EUR, told the troika where to go with their 10 billion EUR rescue package, they set themselves a real problem of where to get the money. Their first idea was Russia, and you can see why, the folks who stand to lose the most in a depositor levy are the Russian depositors. The thing the Cypriots forgot about is that the Russians don't feel bad at all about their people going broke and sometimes they even lend a hand.The other thing to know about the Russians is that if there are assets to be had, they wait until AFTER the fiasco to snap them up on the cheap. What's more, as anyone who has ever owned a GKO can tell you the Russians know a thing or two about putting the creditors against the wall and they probably think the Cypriots are cowards for even asking for help before an actual default. So as you might imagine, the Cypriot emissaries to the Kremlin have got bubkus.

Well, as I write this the Cypriot parliamentarians are probably rocking out of bed to go legislate their newest plan which is to carve the banking system in two: a good bank and a bad bank. They'll put the insured deposits and the performing assets in the good bank and hope it keeps trundling along. Then they'll put the uninsured deposits and the sketchy assets in the bad bank and slowly wind it down. The key word here is slowly. As you can see from my favorite document, 80 billion of the 120 billion are loans, there are only 10 billion in securities. So the bad bank is going to have to liquidate a loan book which will probably take a lot of time. For this reason the parliamentarians are going to have to limit the capacity of people to remove their money from the bad bank since it will be instantly highly illiquid. Capital controls in an Eurozone state, even if temporary, are a serious source of concern and might make people think that the 10% one time levy might have been better. Yep, that vote looks less smart by the minute.

So then there's the question of whether this is a "Lehman Event" for the Eurozone. I don't think so, even in a worst case scenario where the good-bank/bad-bank thing doesn't work out and you have a sovereign default and Euro exit by Cyprus. I believe this for three reasons.

1.) Scale-- when Lehman went bankrupt it's balance sheet was $639 billion, that's five times the size of the entire Cypriot banking system. The CDS auction to determine the likely recovery rate yielded $0.08 on the dollar implying over $500 billion in losses. This is not even remotely that large. Even a Cypriot sovereign default would not be the end of the world, it's total debt is only 14 billion Euros and at this point I doubt very highly that there are any highly concentrated holders of Cypriot paper outside of Cyprus who would be pushed to the edge by taking a loss on it.

2.) No transmission mechanism-- Lehman Brothers, and with it AIG were major players in the global financial system and had massive counterparty exposure to virtually every other bank in the world. The speed and the potential breadth of the contagion were massive. What's more there were a lot of securities on the Lehman and AIG balance sheets that might be dumped into illiquid markets which were nonetheless used to mark the books of all the other banks in the world which could cause a chain reaction simply through mark to market losses. None of that is possible in this case. Not only are the notional amounts low since almost the whole asset side of the balance sheet is loans just working out of them to pay off the uninsured depositors is probably going to provide lifetime employment for the 8,000 finance sector workers in Cyprus. Unlike a real player like Italy or Spain the scale of the sovereign debts of Cyprus are not large enough to take down any of the European banking system.

3.) Cyprus is a unique case-- as I have repeatedly argued in this and my previous post, there are many things that set the Cypriot banking system, balance sheet, fiscal situation and political circumstances apart from the rest of the Eurozone. I think the ECB, EU and IMF are serious when they say that the solution they proposed in this case was uniquely tailored to the circumstances that prevail in Cyprus and that they are not likely to be used in the case of Spain or Italy. It is disturbing to set the precedent of harming the insured depositors but it was the least bad of most options for the depositors themselves. I think that it's possible that the markets think this if this weeks auctions were any indication.

So though I think this is a special case and I continue to think that this is not even remotely as dangerous as the Lehman/AIG fiasco in September 2008, if enough big investors just read the headlines and don't pore over the balance sheets of the banking system, if they refuse to take the ECB and the EU at their word and decide that a Spanish depositor is just as at risk as a Cypriot then whether I've made a logical argument or not won't matter at all. Market psychology has a logic all it's own and in the event that the markets decide to punish the troika for this then there's no argument anyone can make. If only a few investors panic, then this could be a great buying opportunity. That said if the panic becomes general then, as in 2008, there's no telling where it ends.

Logically, this should be a minor event but, the world doesn't run on logic. It runs on the seven deadly sins and the weather. Thanks for your time.

Monday, March 18, 2013

Why Cyprus Doesn't Matter

Shhhh!!! Don't let them hear your Russian Accent...

So yesterday the Eurozone member states, the ECB and the IMF shocked the world with their demands that depositors in Cypriot banks take a haircut in order to help pay for the rescue of the country's financial system. The shock comes because the nature of what was asked was that uninsured depositors take a 9.9% haircut and, and this is the main point, the INSURED depositors should take a 6.75% haircut. This is unprecedented, the whole point of having deposit insurance is that insured deposits are supposed to be the safest assets there are, you literally cannot lose money because in the event that the bank folds the government is supposed to make you whole.

In a piece of excellent reporting the FT described how this came to pass: it was essentially a coordinated ultimatum from Germany, the power behind the EU since it is the largest contributor to any rescue, the ECB, and the IMF.  The decision produced instant outrage and, to some extent, unreasoning fear in the markets. The Euro dropped a big figure and the Yen rallied 2% as money fled the Eurozone and headed for "safe havens." Pundits in the twitter-sphere high fived each other for beating the Wall Street sell side analysts to the punch in declaring this a terrible precedent that could well push the Euro-zone back into crisis. When the S&P futures opened Sunday night, they were down a percent before Asia even opened. It was a panic.

At the same time as the news was coming out so was a lot of punditry that drove the panic. Various financial journalists were appalled that the Germans, the ECB, and the IMF would collude to destroy the small depositors in Cypriot banks. Not only that, they were demanding that the Cypriot depositors pay up before the bank bondholders and shareholders would have to pay. This seemed like an outrage. What's more, if you imagined that this was going to be the modus opperandi for future rescue packages from the European Stabilization Mechanism then the odds that other countries would choose to apply for them, and thus receive massive speculator destroying ECB bond purchases would decline thus increasing the probability of a reignited speculative attack on the solvency of the Eurozone countries. Pandemonium was on the way and this is why the markets crashed last night and early this morning.

The trouble is, and I pointed this out on twitter yesterday afternoon, Cyprus is a VERY VERY special case and the troika went after the depositors in Cypriot banks for very specific reasons that do not apply to any other country in the Eurozone. Everyone in power knows this but the general reader and the average financial journalist does not. So I will spell it out for you.

The first thing to know about Cyprus is that since the 1990s it has had a very special tax treaty with Russia. The original purpose of this tax treaty was to prevent double taxation of income from investments in Russia which originated in Cyprus, it has had the effect however of making Cyprus an offshore tax haven for Russians both to invest in Russia and to have their money technically outside the Russian legal system. As you might imagine this has had a profound impact on the financial system in Cyprus. Remember that the economy of Cyprus is small. It has a population of 1.1 million, a labor force of about 450,000, and a GDP of about 16 billion EUR. This tiny country has a banking system with 107.8 billion EUR in deposits or 660% of GDP. In the US, bank deposits are about 83% of GDP. So here you have a massive financial system, which actually employs 7% of the working population in Cyprus, funding Russia and providing safe haven for Russian depositors in its banks. What's more E35 billion of the deposits on the Cypriot banking system are in amounts under 100,000 EUR which means they are insured by the Cypriot state.

Now since the financial crisis in 2008 Cyprus has had many of the same problems as Greece with regard to it's solvency and some of the problems of Iceland and Ireland with regard to it's banks. This past weekend those problems came to a head and Cyprus was forced to seek help from other Eurozone members. This presented the IMF, the ECB and the Eurozone member states with a very serious problem. Is the Cypriot state deeply mired in debt? Yes. Will it need to be rescued? Most likely. Is the Cypriot banking system insolvent? Yes, the largest bank in Cyprus is in such bad shape it no longer qualifies for the ECB emergency funding program established in December 2011. Is the Cypriot government capable of making whole the $35 billion of deposits under $100,000 in it's banking system? Not even remotely, Cypriot central government revenues are about $10 billion and it's expenditures are already $11 billion. So what we have here is a collapse in the banking system which, through the deposit insurance scheme will lead to a collapse of the central government finances, which will in turn lead either to a government default or a Eurozone exit either of which may very well result in the reignition of the general Eurozone panic. Time to call in the cavalry: the IMF, the ECB, and the ESM (primarily Germany.)

 It might be tempting to draw a comparison with Greece, which the ESM (nee EFSF) did rescue. There are two differences with that which make Cyprus more complicated. First of all, the main problem in Greece was that the day to day operation of the Greek government was unsustainable. In the case of Cyprus, which does have fiscal issues, there is an acute crisis in the banking system which is forcing the hand of the government early. Second of all, the primary beneficiaries of a rescue of the Cypriot state, and with it the Cypriot banking system aren't even Cypriots, they're not even Eurozone members, hell, they're not even members of the European Union. They're Russians.

According to the ECB, 35EUR billion of the 108EUR billion deposits are from outside the Eurozone, ie Russia. Of the remaining, it's pretty hard to know because Russian money may well be behind an EU incorporated SPV. To come up with an estimate, lets imagine for a moment that the amount on deposit in Cypriot banks by actual Cypriots is similar to that in the Germany which has a 130% bank deposits to GDP ratio, that would mean that something like 80 billion EUR is on deposit in Cypriot banks from Russian account holders much of that is probably decomposed into several accounts below the 100k EUR insurance level to take advantage of the insurance.

I can see the Germans connecting the dots and thinking: "Hold on just one second here. In order for us to defend the Euro and prevent a Cypriot default and potential exit we have to make a bunch of Russians whole on 80billion Euros? What kind of interest rate have they been making on these Cypriot deposits the past few years? 8%? Meanwhile back in Germany depositors in our domestic banks earn next to nothing. And we are going to tax them to rescue these guys? Oh HELL NO! I've got a better idea, why don't we make them pay for their own bailout by confiscating about 10% of their deposits? They'll never miss it, I mean what is that? 5 quarters of interest? To hell with them, let's charge 'em." And that's why they did what they did.

"But wait!" You can hear the financial press exclaim. "What about the retail Cypriot depositor? What about them?" Well, let's look for a second at that. If there are 35 billion EUR in "retail deposits" and 450,000 working age Cypriots that would mean that the average Cypriot has about 78,000 EUR or 5 times the percapita GDP of the country in the bank. Is this likely? Not at all, in fact it's impossible. It is by far more likely that a majority of the accounts under the 100,000 EUR threshold are not retail Cypriot accounts at all but, as mentioned, are Russian accounts purposefully trying to take advantage of Cypriot deposit insurance. So by going after the "small depositors" the Germans are actually going after the more clever Russians.

It is also important to keep in mind that no one can say that this is what is being done. Still less can the implement a policy which specifically targets Russians. There is some effort being made to make the tax 0% on deposits under 20,000 EUR which would probably protect most Cypriots, but the troika had to appear to be addressing everyone equally. Remember, Europe still depends on the goodwill of Russia for it's gas supplies and Russia has many ways of making life difficult for the Eurozone generally.

So what can you take away from this? Well first of all, Cyprus is very much a special case because in its rescue the Germans are being asked to save an EU member state by rescuing depositors in an EU banking system who are themselves based outside the EU and they are saying no. This is not at all an equivalent to what would happen in the event that something similar were to happen in Spain or Italy, both contributors to the ESM, Eurozone members, and EU members. So I don't think anyone should worry about this decision being used as a precedent for other Eurozone states and as people begin to understand that more fully I think the markets will recover. The other lesson is that when the banking system is too large for the government itself to rescue, terrible things happen and as I have written, that is the case in pretty much every state in the Eurozone. So while this will blow over, the larger storm is still coming.