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Do you think that depositors in Cyprus are being taxed?
That their money is being taken from them to go to the government in Cyprus or
to Europe? Most analysis of the Cyprus bailout is wrong on this point.
Cypriot banks are like all banks in one respect. They
raise capital to buy assets that earn a yield, keeping the difference between
what they must pay for the money and what they earn on it. Like all banks,
they raise money first from equity investors. Equity investors get to keep
all of the gains on the upside and therefore are first exposed to losses on
the downside.
Banking uses leverage, which multiplies gains when
assets rise and losses when they fall. Imagine using 20:1 leverage. You buy a
house for $100,000 using $5,000 of your own money (equity) and $95,000 of
borrowed money. If the house rises to $110,000 you have tripled your $5,000
of initial equity to $15,000. If the house falls to $94,000 you have negative
equity. That may be fine for a homeowner so long as you can pay the interest
and principle when due. It's not fine for a bank.
Banks raise money next from junior, unsecured
creditors. Equity capital is expensive capital. Borrowing money is cheaper
than selling a stake in the business. Next on the capital hierarchy is senior, secured creditors. Borrowing at this tier is
cheaper because the risk of loss is lower. Not only would the shareholders
have to be wiped out first, but also the junior creditors. Additionally,
secured creditors can take the assets pledged as collateral.
Finally, banks raise money from depositors. Depositors
get the lowest rate of interest, which is the tradeoff for having the
strongest position in case of bankruptcy. In addition to not suffering any
losses until all other classes of capital are zeroed out, depositors also
enjoy a government guarantee today, at least up to a certain amount
(€100,000 in the case of Cyprus)--so long as the government can pay. It
is important to note that while the government maintains the fiction of a
"fund" to cover such losses, in a bank crisis the losses are
imposed on the taxpayers. Today in the US, for example, the FDIC has a tiny
reserve to cover an enormous deposit base.
In the modern world, government bonds are the key
security in the financial system. They are defined as the "risk free
asset" by theory and regulatory practice. They are used as collateral
for numerous other credit transactions. And banks hold them as core assets.
Let's focus on that. A bank borrows from depositors and buys a government
bond (and not entirely by choice). There are two problems with this.
First is duration
mismatch. The bank is borrowing from depositors, perhaps via demand
deposits, and then buying multiyear bonds. Read the link to see why this will
sooner or later blow up.
Second, the government bond is counterfeit
credit. Governments are borrowing to pay the ever-expanding costs of
their welfare programs and the interest on their ever-expanding debt (it is
no help that they lower the rate of interest to keep down the interest
expense--this increases their burden
of debt and destroys
capital). Governments have neither the means nor intent to ever repay the
debt. They just endlessly "roll" the liability, selling new bonds
to pay the principle and interest on old bonds at maturity. This would be
like taking out a new credit card to pay off the old one. It
"works" for a while, until it abruptly stops working. It has
stopped working in Greece; it will stop working everywhere else at some
point.
The Cypriot banks bought lots of government bonds,
including the defaulted bonds of bankrupt Greece. They lost the euros that
were invested by their shareholders, bondholders, and a majority of what was
lent to them by depositors. In a way it is accurate to say that the
government took it. However, his taking did not occur this week. It occurred
when governments sold them fraudulent bonds over many years.
The money is now long gone.
Call it what you will, the government, central bank,
and commercial banks of Cyprus are bankrupt; they needed a bailout--new
credit from outside the country to postpone collapse. In a week of drama,
posturing, demands, reversals, and a vote in parliament, a
deal was struck. No one is likely to be happy. Here are the key points
so far as we can glean them:
- A fresh tranche of €10B will be lent to
Cyprus
- Funds to come from (presumably?) the
"Troika": ECB, EC, and IMF
- Shareholders and bondholders in Laiki (2nd biggest bank) will be wiped out
- Laiki deposits under €100,000
will be transferred to Bank of Cyprus
- Larger deposits will bear big losses (not
specified at this time)
- No bailout funds will go to Bank of Cyprus
(presumably to government?)
- 50% or more of large deposits in Bank of Cyprus
converted to equity
- "Temporary" capital controls will remain
when banks reopen Thursday
- CEO of Bank of Cyprus just resigned, fueling
rumors it too will collapse
The Europowers have a big
dilemma. If they allow euro backwardation
to persist much longer, or they open a schism in the euro where Cyprus euros
are not fungible, they risk the collapse of the euro. On the other hand, if
they do not impose capital controls then depositors would run on the Bank of
Cyprus and it will collapse (ZeroHedge has been
covering the story
that large Russian depositors have found ways to make withdrawals even though
the banks have been closed, using branches located outside the country).
We hope that if the reader gets nothing else from this
article, at least he now understands that the Cyprus banks lost their
depositors' money over a long period of time. They used leverage to buy
assets that collapsed and now they are insolvent. External parties are
providing a bailout (which Cyprus will never be able to repay). For the first
time in this crisis, the bailout does not cover depositors in full. Losses
are to be suffered by not only shareholders and bondholders, but even by
depositors. We expect future bailouts to incorporate this feature.
It is good that Eurozone leaders are beginning to
assert that banks should fix themselves. In a free market, there is no such
thing as a bailout that takes money from taxpayers to give to those who made
a mistake. Hopefully they will take this to the next logical step and realize
that bank solvency is impossible under the regime of irredeemable paper
currency wherein the government bond is defined as the "risk free asset".
Gold is the risk free asset. Everything else has a non-zero risk of default.
We will continue to monitor and publish the gold basis to see when
world markets begin to shift away from trusting the banking system, when
people are willing to forego a yield to avoid having to trust a counterparty. When this happens, we expect gold to move
more significantly towards gold backwardation.
Compared to the first proposal last week, this bailout
is less unfair (we can hardly call any bailout fair)--at least shareholders
go first, then bondholders then depositors.
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