Monday, March 18, 2013

Idiocracy: Why Cyprus Matters

Cross-Posted from the Official Meridian Blog at Meridian Wealth Management.

Late Friday night news began to break of a deal to provide support to failing banks in Cyprus.

Disregarding other details, the deal required all bank deposits under 100,000 Euro (in any Cyprus bank) to have a levy of 6.75% imposed.  For bank depositors with balances over $100,000 Euro, the levy would be 9.99%.  Those who lent money to the bank, known as senior bond holders would continue to be made whole.

In one announcement, a chaos was unleashed on the world that could have far reaching consequences. For a complete run down of what happened and updates see PragCap's post "Sowing the Wind."

Imagine waking up to find you had 6.75% less money in your bank account.  This has not yet happened in Cyprus, it must be voted on, but the banks are on Holiday until that vote happens and no one can move their money.  If the vote happens and passes (my guess is it won't), when the citizenry awakes they will find their bank accounts lighter.

This proposed solution to recapitalize the Cyprus banking system is important to the US and the world for several reasons.

It turns out that the President of Cyprus said that "haircuts" for deposit holders was not a negotiating point just a few weeks ago, but let's take a step back.

When a bank becomes insolvent and is in need of recapitalization there are several ways it can do so, a few of which are:  issue additional stock, convert debt to equity, receive a bail out, tap deposit holders.  In the United States we have something called the FDIC which in addition to providing some banking regulation and resolution also insures deposits against bank failure up to a certain dollar amount, currently $250,000 (its a bit more complicated than that, but you get the picture).  No matter how badly capitalized your bank is in the U.S., even if it fails you are guaranteed to get back every penny of your deposit as long as it isn't above the $250,000 mark.  Cyprus has a similar insurance program, but up to 100,000 Euros...which is why this "levy" is so important and such a stupid idea.

Confiscating 6.75% of a person's wealth who you have guaranteed will never lose a penny is an abdication of a promise.  When a banking system goes back on its word, it loses all credibility and panic ensues. Panic leads to bank runs.  Bank runs lead to collapse and contagion.  The biggest problem with this "levy" is that it comes from (or appears) to be come from the European Central Bank (ECB) (and more so, Germany) and thus sets a precedent of how other troubled nation banking systems could be approached.  If it could happen in Cyprus, why couldn't it happen in Spain, Italy, Portugal or any weak country with the ECB as its banker? A bank run in Cyprus could lead to capital flight in other countries as depositors fear confiscation. Such contagion could lead to meltdown.

Another issue is that the senior bondholders are not getting hurt.  Granted, if you converted all the senior debt to equity, you haven't come close to solving the problem - but requiring insured depositors to take a hit and making bondholders whole is sending a bad message.  Worse, by levying against smaller depositors who were supposed to be insured against loss, the levy against the very rich (in this case Russian Oligarchs) depositors only needed to be 9.99%.  Remember, those with balances above 100,000 Euro are taking a chance with their deposits, they have counterparty risk and knowingly accept this - in effect they are creditors of the bank (yes, technically all deposit holders are creditors, but not in reality if there is real deposit insurance).  By hitting the insured depositors with a 6.75% levy the rich deposit holders avoided what likely would have been a 30 - 40% hit to their account balance.

Again, this sends the wrong message - we will defend the rich at the expense of the less powerful poor.

Not allowing insolvent banks to fail and not wiping out bondholders and unsecured creditors may be the right thing to save the "system" (though I doubt it), but it sends the message that the elites will be protected at all costs.

Cyprus matters both because of the deal that was made (but not yet voted on) and for how the deal ends up being implemented, if at all.  If insured bondholders are forced to take losses, panic and contagion may be the outcome in other weak Euro nations.

I don't believe the vote will pass, after all, these politicians don't have very far to run - it is an island after all.  This begs the question of what happens next, either way it will be interesting to watch.

Regardless of what happens, you can chalk this up to complete idiocracy.

Scott Dauenhauer CFP, MSFP, AIF