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Some of the world’s major crises began with events that looked more benign than Cyprus, but reverberated beat by beat into global messes, notes David Kotok of Cumberland Advisors.

History indicates that contagions start small. What is worrisome about Cyprus is the complacency that markets are showing, based on the assumption that it is a little, one-off, insignificant event.

Here is a little refresher on contagion:  

  1. The Russian ruble collapse in 1997 and 1998, which actually started with a single-currency failure in Thailand. The contagion from that event took about 18 months to play out, ending with the collapse of the Russian ruble and the demise of the Long Term Capital Management (LTCM) hedge fund, which triggered a large government intervention.
  1. The earliest signs of Zimbabwean inflation—confiscation of wealth, appropriation of property, and oppression of the populace in Zimbabwe—appeared many years before hyperinflation, full destruction of the currency, and suppression of the productive facilities of the country.
  1. Weimar Republic hyperinflation started with currency expansion and banking manipulation, in an attempt to manage foreign-exchange flows. It ended with hyperinflation, the demise of the government, and the rise of Nazism in Europe.
  1. The US financial crisis of 2007-2009. We saw the first signs of weakness in the financial sector in mid-2007. By summer 2007, Bear Stearns had indicated a problem with some mortgage-backed securities. They said it was just a couple of billion dollars—not very significant.

Now let us put this perspective to work with regard to Cyprus. We now know that some bank accounts in Cyprus will lose up to 60% of their balances. Access to the remaining 40% of accounts is limited to small transfers and withdrawals.

Those transactions, when they are restrained or defeated by a punitive Eurogroup policy directed at Cypriot banks, trigger negative multiplier effects that may blossom into serious Eurozone-wide contagion.

Markets are already reallocating funds away from places like Malta and Slovenia, and are worried about larger countries that are also troubled, like Spain and Italy. The most recent unemployment report from the Eurozone validates our view. It is 12%, up from 10% just two years ago.

Markets are also looking at New Zealand, which is proposing an Open Bank Resolution (OBR) mechanism, similar to the one applied by the Eurozone in Cyprus. We suspect that money that is able to leave New Zealand is already doing so.

How does one protect oneself? In New Zealand, one needs to avoid exposure to banks, if possible.

In the Eurozone, we know that the intent is to preserve the insurance limit in each of the 17 countries. We also know that the finance ministers in the Eurogroup wanted to attack small depositors, and would have succeeded were it not for the Cypriot parliament.

In the US, we know that the FDIC has honored its commitment to deposit insurance. The same is true in the UK. We also know that in both countries, there is a new law (not tested yet) that suggests that a bank that has exhausted all resources, and does not have the assets to either merge or be resolved fully without invading insured deposits, now presents an additional risk to the insured depositors.

We do not expect that these insured depositors would lose their funds, but we do note that their safety is not as clear-cut as it once was.

In the US, we are seeing small and independent businesses revamping their deposit allocation structures to stay within the $250,000 limit of the FDIC. We do not blame them.

So what does all this mean for investors?

Contagions start small. Actions of governments can mitigate damage or enlarge it. A second bank failure that is resolved with large depositor losses in Europe will have a much greater systemic impact than the first one in Cyprus. The increasing use of Emergency Liquidity Assistance (ELA) in any Eurozone country will be seen as a warning sign that the Cyprus events may be repeated.

Investors have choices. They can seek higher returns, and will often take risks to get them. Or they can follow the advice often attributed, though perhaps erroneously, to a great economist by the name of Will Rogers: “I am not so much concerned with the return on my money as I am with the return of my money.”

We are in a day and age in which the short-term interest rate in every major currency of the world is near zero. Compensation for risking wealth in a deposit structure is small. Safety is obtainable at low opportunity cost. Investors are wise to seek it.

Read more from Cumberland Advisors here...

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