What Do We Do Now?
Yesterday, we discussed why we thought the combination of an across-the-board bank levy (regardless of institution health), in absence of restructuring the capital structure of banks was a bad idea and bad precedent.
Today, we will lay out what we think should happen. We recognize that we are working with more limited information than the teams actually negotiating the bailout, but we will give it our best shot.
Our parameters for a proper solution are the following:
1. Respect the €100K deposit insurance limit
2. Preserve moral hazard / fairness to bank creditors. In other words, hit the creditors of the bad banks more aggressively than the creditors of the good banks.
3. Have a solution that is sustainable for Cyprus over the medium-term.
This is actually a more more complicated question than it seems and at the crux of our analysis and our concerns about the initially proposed plan.
(a) For better or worse, financial services (broadly defined to also capture accountants, lawyers and other corporate services firms involved in managing the financial services clients) accounts for 45% of Cyprus GDP. A large % of this comes from serving Russian clients and is the most important industry in Cyprus.
With a British Law and British accounting heritage, independent courts and a highly educated population, it is the most natural industry for us, regardless of if Germany is confused about why Cyprus is in this sector. It is something that Cyprus has spent decades nurturing and protecting (often at significant cost to it).
(b) If either the deposit levy is seen as too unfair (and investors leave) or if Russia revokes the double-taxation treaty as punishment for the levy (as threatened today by Medvedev), this sector of the economy would take a huge blow.
We are going to use a completely made up estimate that, over a two year period, Russian departure would cost Cyprus a 15% drop in GDP (reduction of the financial sector by 1/3) with another 5% in knock-on effects for a total loss of 20% of GDP. The total could actually be higher, but we can use this as a planning assumption because whether it is 15% or 25%, it does not change the outcome of this exercise.
(c) This means any scenarios below that involve throwing away the Russian business need to be scored with a GDP 20% lower than our current GDP
We also have a few more variables to throw in the mix that have been discussed publicly since yesterday:
1. Nationalization of Cyprus pension funds and forcing them to lend to the government. This apparently can capture up to 4B.
2. Doing special bond issues to the local population against future oil and gas revenue.
3. The vastly land rich Church of Cyprus has offered to mortgage its land on behalf of the government, though we are not exactly sure how the mechanics of that would work, nor does anyone have any real estimate of the value of said land.
4. On the Russian front, nothing substantive has emerged. There are constant leaks and denials that one or more private Russian actors would purchase Laiki before and/or after a full and/or partial recapitalization.
Given the above, here is our analysis of several possible Scenarios
Scenario A: Government / Troika Track: The Existing Solution +/- some modifications
This seems the most likely approach at this time and what the Cyprus government is discussing with the troika.
1. The troika will lend 10B as in the original plan.
2. Cyprus will then make up the remaining 5.8B through a combination of:
a. Nationalization of pension funds and forcing them to loan money to the government.
b. possibly loans against future oil and gas revenues from the Church of Cyprus and the local population
c. a reduced deposit levy in the 3%-5% range (possibly exempting small accounts).
Initial reports were that the troika rejected this plan because they were afraid that 2(a) and 2(b) would lead to unsustainable debt for Cyprus but surely that is a failure of imagination. These instruments could easily be made subordinate to official lenders or otherwise termed out into the long future at which point they are acting as pseudo-equity for the government.
So we will assume that they can work out the subordination of the local loans.
Our concern about this plan is the following:
(a) Even though the levy is lower than the initial levy, the damage might still be irreversible to Cyprus as a banking center if we apply an across the board levy (or the damage might have already been done from the events of this week).
(b) In which case, the drop in GDP will be coming anyway through the loss of its financial services sector, but Cyprus is still levered up to 120% of its original GDP (as if it had not fallen).
(c) Which means that, within a year or two, Cyprus will be looking at a debt-to-GDP in the 150-160% range which is clearly unsustainable and will either lead to Greek-style austerity or another depositor tax (if there are any left at that point).
We believe the initial Troika plan suffers from this risk as well and is the key risk that needs to be taken very seriously by Cyprus, namely that we lever up to protect the financial services sector, but then lose it anyway.
For us to be supportive of any measure that limits the hit on large foreign depositors, we need to see real evidence that the offshore sector is not fatally wounded, as per our Scenario B below.
We now present three alternative Scenarios B-D for consideration.
Scenario B: Return to Rule of Law / Protect Russia
The basis of this scenario is to preserve the principles of our legal system and to maintain our financial sector.
(1) As it relates to banks:
(a) Shareholders in any of the banks to be bailed out need to be completely wiped out. It is small fries at this stage, but it should happen as a matter of principle
(b) Bondholders should be wiped
(c) Senior management should be replaced and salaries cut bank-wide.
(d) Insured depositors are protected
(e) Uninsured depositors *in the failing institutions* make up the difference. That means that in practice, large account holders in Laiki have the largest haircut, followed by Bank of Cyprus and then Hellenic and the Coops. Other banks that are healthy do not have cuts.
(f) Place a Good Bank-Bad Bank structure in place for Laiki and possibly BoC with a Resolution Corp in charge of unwinding the bad assets
(g) Merge the Good parts of Laiki with BoC - there should be significant operation savings in branches, etc.
(2) The messaging to the offshore sector, despite the chaos of this week, would be the following:
(a) "We voted in, the face of the annihilation from Europe, to protect your deposits. Where else do you have that security in the EU?
Malta, Luxembourg, Latvia all have similar EU pressure and risks. Malta has 7x bank assets:GDP and Luxembourg 21x bank assets:GDP and are in the Euro so they are one accident away from also being at the mercy of Germany. Latvia is within the EU, has applied for the Euro and, furthermore, its bank sector controlled by German banks. Ireland is under a package of its own. So, the usual suspects (for an EU entity) face similar risks as Cyprus.
Furthermore, you do not know how they will respond under external pressure. Whereas, we are proven - we took on the ECB, the IMF and the EC to deliver for you."
(b) We protected your deposits (the ones in your own, Russian or English, highly-rated institutions). If any serious investor was still in Laiki as of March 2013 given years of downgrades into junk status by the major agencies, then, honestly, he or she has only himself to blame.
(c) These are the same rules of the road you will find in any serious jurisdiction -- aka there is predictability in creditor precedence and predictability in which banks are risky or not and innocent bystanders are not hurt.
(3) As it relates to the government:
Immediate cuts in spending. We need to do this anyway. It is no 'victory' to preserve salaries and deficits when the deficit funding is coming at such high cost in sovereign autonomy. For the same reasons, the SGOs should be privatized.
(4) To the degree that any additional funding is needed, use the additional sources from Scenario A (pensions, etc)
This is the theoretically best plan in our mind but for us to to support this plan, we would like to see some sense of real official support from Russia that shows they consider it acceptable and will support Cyprus's continued role in financial intermediation. This could include:
(a) Even a nominally small loan of 500M-1B euros on the same terms as the Troiaka (just to show commitment to the plan, in exchange for their depositors not being burned)
(b) Re-affirmation of the tax treaty
(c) Positive statements about deepening ties
If this is not achieveable, proceed to Scenario C
Scenario C: Burn the Russians
This would be our modification of Scenario A.
If one comes to the conclusion that the offshore business is gone in any case (see recently articles in WSJ, Medvedev's statements about cancelling the tax treaty, etc), then you might as well burn them hard and reduce your debt burden to a level sustainable by an 20% smaller economy.
By our rough calculation, we think that is an additional 4-5B euros minimum haircut from the non-EU depositors. They might yell and scream, but, hey, they are gone anyway...
In any case, this Scenario C is much better leverage in bringing the Russians along on Scenario B than offering to sell them Laiki.
In this scenario, you still resolve the banks, cut government spending, privatize the SGOs and so on.
Solution D: Self-Bailout (Burn everyone)
This it the model for the 'patriots' to follow, if they have the stomach for it.
Their patriotic, reflexive approach to date is 'leave the Euro' which is moronic and will leave Cyprus with an immediate drop of national wealth in the range of 50-60% as the NCYP (New Cyprus Pound) would have a hard devaluation immediately and no access to the ECB.
If one is willing to take that type of pain in order to achieve independence from foreigners, there are better solutions within the Eurozone as follows:
1. Cram down the sovereign bond-holders. If they don't accept, hard default on the June refinancing. Even though they are English Law bonds, Cyprus has almost no assets outside Cyprus that we can think of that they can freeze. So let them go to court and play for time. In the meantime, don't pay them (since, anyway, you don't have the money to pay them)
2. Cut government spending dramatically in order to run a surplus (Cyprus won't be borrowing on the international markets any time soon in this model), privatize SGOs, etc.
3. Resolve the insolvent banks as per Scenario B AND burn the offshore depositors as in Scenario C
4. Supplement with nationalization of pensions and Church of Cyprus support as needed.
5. At this point, you have no official creditors, can control your own policy and you hold out until the oil/gas comes online
6. As it relates to the ECB, request ongoing support with the solvent banks, including the Good Bank, as per ECB rules.
We don't recommend this path. But if things start going astray and the alternative is Euro exit, in our opinion, this is better. And theoretically the Northern countries should be pleased that we are not asking for any of their money and glad that we are not setting a 'leave the Euro' precedent.
It is disappointing that these are the options on the table as none of them are ideal. In our opinion, Scenario B was workable and should have been worked out behind closed doors. It would have been a very reasonable and fair solution and would have not damaged Cyprus's reputation the way that this week's events have. If the Troika wasn't so intent on intimidating Cyprus into a solution and (for reasons not known to us) insulting Russia, it could have been done this way.
At this point, it is mostly a judgement call of 'is the offshore business beyond recovery under any model?'
If not, then we should do Scenario B to save it. If it is, we should be hard-minded and do Scenario C and at least leave Cyprus in a fiscally survivable position.