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.

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