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Monday, March 25, 2013

Troika Plays Russian Roulette in Cyprus; Laiki Takes the Bullet

So Cyprus and the troika have reached an agreement on the terms of the Cyprus bailout / bail-in.  With respect to the financial sector, which is the largest sector of the economy and the root of its insolvency,  the terms amount to a game of Russian roulette (maybe the troika thought the Russians would accept something named after them):

Insured depositors throughout the Cypriot banking sector are left unimpaired (it is ambiguous whether they remain subject to temporary withdrawal limits, as the press release says "Only uninsured deposits at BoC will remain frozen) or the capital controls yet to be determined).   At the two largest banks, referred to in the press release as BoC and Laiki, bondholders and equity appear to be wiped out.   At Laiki, uninsured depositors are also apparently wiped out.  Its performing assets and insured deposits apparently will be transferred to BoC, along with 9 billion euros of Emergency Liquidity Assistance from the ECB, and BoC's uninsured depositors will be equitized in some yet to be determined percentage to bring its capital ratio to 9%.  So one gets liquidated, the other gets reorganized.  Of course, all of this is "after having heard the Boards of Directors of BoC and Laiki" (what are they expected to say - please, allow us as fiduciaries to wipe out our stakeholders voluntarily and save you the trouble? Seriously, what Laiki director in his or her right mind would show up and vote for a complete zero for all of its stakeholders?).

The terms say nothing about any of the stakeholders (other than insured depositors) in other banks in Cyprus.  One cannot tell what the "newly adopted Banking Resolution Framework" consists of.  So for now, subject again to limits on withdrawals, stakeholders at every other bank appears to have escaped the troika's scythe for the time being. while Laiki is summarily executed.  That was the bank holding the pistol when it discharged, I guess.

This reminds me a great deal of the aberrant, ad hoc actions of Treasury Secretary Paulson during 2008. One bank is recapitalized on government dictated terms, supported by government financial aid, a la AIG or Bear Stearns.  Another is put out of business, a la Lehman. Others are left unscathed a la B of A.  No explanation is given what principle was applied to generate these disparate outcomes.

It remains to be seen how this seemingly random selection of winners and losers by distant bureaucrats affects market stability and liquidity even among the seeming winners.  In 2008, we saw significant second-order effects when the unplanned liquidation of Lehman in the US caused its substantial UK operations to freeze billions of dollars of investors' assets and the ripple effect that had on liquidity throughout the financial system worldwide. Already, as Business Insider reports, Laiki's UK affiliate (probably smaller than Lehman's fortunately) has frozen up.  Similarly, in 2008, the government-directed bankruptcy of Lehman promptly led to runs at other holding companies like Morgan Stanley and Wachovia that nearly bankrupted both of them.  I would expect that every depositor above 100,000 euros in every other bank in Cyprus (and even many below) would be trying to get their money out as fast as possible, most likely to send to Hong Kong or Singapore, which of course is why the Eurozone has required Cyprus to institute withdrawal limits and capital controls.  But those will just  cause liquidity issues for those depositors elsewhere in their affairs.  And in the long run, those banks are going to have to liquidate their own assets to meet even the reduced withdrawal demands, since no new money is going to come into them under current terms, except possibly via the Central Bank using funds supplied by ECB, also left unspecified in the term sheet.  And we saw similar liquidations of financial assets by leveraged investors in late 2008 after Lehman was shut down.

In so many ways, this seems a lot like what Paulson did in 2008, to disastrous effect.  The only difference may be (1) size and (2) hopefully many fewer of the depositors in Cyprus banks are not themselves leveraged financial firms, in which case the effects will not spill over as much.  That remains to be seen.

Macro Man translates the Eurogroup press release very nicely: