What's a safe asset? Cyprus greases the global slippery slope

03/28/2013 1:09 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

(I'm taking a couple of days to backpack part of the C&O Canal path with my kids. So I'm posting this early.)

As I look at the continuing Cyprus banking tragedy/farce, I keep thinking of Willie Sutton.

Sutton was a career bank robber—credited with 100 bank robberies—most famous for a quote attributed to him after reporter Mitch Ohnstad asked him why he robbed banks. “Because that’s where the money is,” Ohnstad wrote that Sutton said.

So why did the EuroZone force bank depositors in Cyprus to pay almost 6 billion euros toward the bailout of the country’s banking system? Because that’s where the money was.

And that should be deeply troubling to anyone who lives in a country with a deeply indebted government. (And who doesn’t these days?) Looking at Cyprus, you don’t have to be paranoid to think “they” are coming after your money. That cynical conviction is a slow growing but very serious threat to global financial markets are they now exist.

Let’s start with Cyprus. In the days after the late night Sunday deal that “ended” the crisis with something short of the country’s immediate departure from the euro, Jeroen Dijsselbloem, the new Dutch head of the group of EuroZone finance ministers, set off a firestorm by saying that this deal would be the model for future bailouts.  “What we've done last night is what I call pushing back the risks. If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalize yourself?’ If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalizing the bank, and if necessary the uninsured deposit holders.” In the following days Dijsselbloem and other EuroZone officials attempted to walk back some of those comments by stressing that Cyprus with a banking sector eight times larger than its economy was a unique situation.

But frankly nobody much believed those “clarifications.” Cyprus clearly was a new “template.”

And that’s deeply disturbing—even if you don’t live in the EuroZone.

Of course, it’s deeply disturbing if you do live in the EuroZone because the deal violates so many of what everyone had thought were the basic rules of the euro. For example, the whole idea of a currency union is that the common currency is worth the same in every country in the EuroZone. Tell that to Cypriots who could only take 300 euros out of their banks when they finally reopened on Thursday, March 28. Tell that to Cypriots who can’t take more than 1,000 euros in cash out of their country. Tell that to Cypriots who can’t transfer euros out of their country. Today a euro is Nicosia isn’t worth the same as a euro in Berlin or Paris or Milan.

But it’s the deal itself—and the way it developed—that should be disturbing to people who live outside the EuroZone as well.

Like just about every “solution” implemented during the euro debt crisis this one was ultimately political. The “need” for a bail-in, for a contribution from someone in Cyprus toward the price of bailing out the country’s banking system, was the result of a political calculus that looked at what EuroZone taxpayers, and especially German taxpayers, could be expected to stand for without costing German Chancellor Angela Merkel her country’s September election.

Once that principle was established, then the issue became one of trading political pain within that formula. Initially the newly elected president of Cyprus Nicos Anastasiades proposed a formula that would have confiscated money from all bank accounts. That was a good idea, Anastasiades thought, because it would diminish the hit that the largest depositors in Cypriot banks would take. That would lessen the risk of alienating the Russian money that had become so crucial to Cyprus’s offshore banking industry. (Russia might even contribute to the bailout, the president apparently hoped.) This deal only went down in flames when EuroZone officials pointed out that it ran afoul of deposit guarantees for accounts of 100,000 euros or less.

The next bright idea out of Nicosia was to set up a national fund that could be used as collateral for loans (from the European Central Bank, it was assumed) to bail out the banks. And what would go into the fund? How about assets from national pension plans? This idea too went down in flames when the European Central Bank said it wouldn’t lend on that basis. (It’s not clear whether the bank was appalled at the proposal or feared that it would lose money it lent against this collateral.)

Against this background, the final deal looks—on the surface—like a model of fairness. Deposits under 100,000 euros remain guaranteed against loss. Only big depositors lose money and then only depositors at the country’s two biggest banks. The country’s second largest bank will be wound up with “good” assets being transferred to the country’s largest bank.

The deal also has the advantages that it gives Northern European politicians the ability to point to the pain being distributed in Cyprus to mollify voters who just might object to another bailout in the south of the EuroZone. (And it seems, once again, to make sure that the European Central Bank doesn’t take a loss—so far--on the emergency cash it lent Cypriot banks to keep the country’s banking system functioning.)

Yep, from some perspectives this is a pretty great deal.

But reverse that perspective and look at this deal from the point of view of someone with money in a Cypriot bank.

Let’s not focus our attention on the average Russian oligarch who was using Cyprus as a way to hide money or business activities from authorities in Moscow and elsewhere. Initial money flows suggest that some of that money got out of the country in the days before the deal. And I’m pretty sure that the managers of this money weighed the risk of putting cash in Cyprus against the risk of depositing it elsewhere.

Let’s instead look at the average Cypriot account holder or the average Cypriot business with money at a bank on deposit against future capital needs or future needs to pay bills. That account holder woke up to a crisis that threatened the safety of the country’s banks and then, surprise, got presented with a new set of rules. The big one, of course, is that money in some bank accounts would be confiscated to pay for a banking bailout.

Today the politicians are promising that these new rules are stable—and that the government won’t need to extend these measures to other banks and other account holders. But that’s clearly no more believable than the government’s projections that this deal will only cut 3.5% off of the country’s GDP in 2013. 10% looks like a more reasonable figure. And if the economy tanks to that degree, anyone with any experience of the way the euro debt crisis knows, more Cypriot banks will need more cash, the government will run even more deeply in the red, and Cyprus will be back looking for more bailout money.

And if in this stage of the crisis politicians in Cyprus and in the EuroZone were willing to change the rules so they could go “where the money is,” it’s a reasonable fear that they’d be willing to change the rules again in any renewal of the crisis.

And now that this willingness to go where the money is has been established in Cyprus, do you think it hasn't entered the political calculations in Madrid or Rome or Athens or Lisbon or Paris? Governments in these countries now have to consider the very real possibility that they will be asked to go where the money is should they need a banking bailout or further support for their government debt. You can bet that these governments are hoping as hard as they can hope that European Central Bank president Mario Draghi’s promise to do whatever it takes to defend the euro continues to work its bond market magic. Because if it doesn’t, they know post-Cyprus, that the list of what they might have to do to win EuroZone support for an actual bailout contains some pretty unpalatable measures.

Savers and investors in these countries are facing a new calculation too. In the light of the kinds of things in this deal—and the even more draconian measures proposed by the government in Nicosia that didn't get into this deal—what banks can they trust? What financial institutions are safe? And most importantly how much can they trust their own governments not to go after their financial assets in the next crisis?

So far, the money flow numbers suggest, these worries have produced modest shifts from weaker domestic-only banks to stronger internationally diversified banks. But it’s early yet and I don’t think we have the data to indicate the full extent of any Cyprus effect.

And any Cyprus effect won’t fully kick in until a new crisis—somewhere else—demonstrates that Cyprus is, as Dijsselbloem said, a new template.

It is, unfortunately, not just a new template for the EuroZone either.

It’s hard to honestly confront the budget deficits and the deficit trends in the United Kingdom, Japan, and the United States and say “That can’t happen here.” Oh, not tomorrow or next week, maybe, but sooner than any of use would like to think.

In the U.S. budget debate, for example, you can hear snippets of talk about the need to “reform” the mortgage tax deduction. The talk isn’t about doing away with the deduction entirely but instead about a need to cap it and put some limit on the size of the mortgage deduction that can be claimed against taxes.

That's never been on the table before in even this kind of glancing way.

I wouldn’t argue that all attempts to go where the money is are bad. The current system of guarantees for this and tax breaks for that is arbitrary and illogical. It’s a reflection of the power of lobbies and constituencies.

But the danger here, as I think Cyprus illustrates, is that we continue to slide down a slippery slope toward a future where every “solution” to a very real set of interlocking global crises seems like an arbitrary grab at this or that pool of money. That, as Cyprus illustrates, threatens to create a crisis in which no one feels any savings or investment is safe from tomorrow’s change in the rules. (How about all that tax-deferred 401(k) and IRA money, for example?)

At the extreme that would lead to a day when we’d all be out in the backyard in the dark of night burying our gold. And no one would call us paranoid. You aren’t paranoid if “they” really are out to get you.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own positions in any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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