WTF is happening in Cyprus?!

This is crossposted from mathbabe.org. Opinions expressed are those of Cathy O’Neil.

One thing I kept track of while I was away was the ongoing, intensely interesting situation in Cyprus. For those of you who have been following it just as closely, this will not be new, and please correct me if you think I’ve gotten something wrong.

Background

Cyprus banks have recently gotten deeply in trouble, partly because of their heavy investment in Greek government bonds which as you remember were semi-defaulted on in spite of them being “risk-weighted” at zero, and partly because of an enormous amount of Russian money they hold (Russian businessmen enjoy lowering their taxes by funneling their money to Cyprus), which created a severely bloated financial sector.

To be fair, just having deposits of rich Russian businessmen doesn’t make you fragile. But it’s just not done in banking, I guess, to simply hold on to money – you have to invest it somewhere, and they invested poorly.

To get an idea of how bloated the finance sector is and how badly the banks were hurting, if the Cyprus government was to give them the money they need, it would be 70% of GDP, and they’re already about 90% of GDP in debt. Even so, that’s only 17.2 billion Euros, or a bit more than twice Steven Cohen’s personal fortune ($10 billion) even after his firm, SAC Capital Advisors, settled with the SEC for insider trading “without admitting nor denying wrongdoing”.

What are the options?

  • Do we ask the government of Cyprus to prop up the failing banks? Then it (the government) would be underwater and people would stop investing in its bonds and we’d need a bailout of the government. In other words, we’d just be handing the hot potato to the people.
  • Does the EU or IMF loan money to government to give to the banks?
  • Or to banks directly? Either way this would feel wrong to the northern European taxpayers, who would be essentially bailing out a bunch of Russian businessmen. Europeans are suffering from bailout fatigue, and German elections are coming up, making this even stronger.
  • Or do we make the banks deal with their solvency issues themselves? After all, their shareholders, bond holders, and depositors all represent money they have which they can theoretically keep.
  • Or some combination? Actually, all plans below are combo plans, whereby the banks make themselves solvent and then, after that, the EU/IMF team kicks in a few billion euros. Whether it will be enough money after the ricochet effects of the plan is not at all clear.

Plan #1: anti-FDIC insurance.

The plan as of more than a week ago was to take money from all the accounts as well as bond holders and shareholders. This included even the so-called insured deposits of accounts below 100,000 Euros.

So normal people, who thought their money was insured, would be paying 6.7% of their savings into a so-called “bail-in” fund, and people with more money in their accounts would be paying 9.9%.

This was across-the-board, by the way, for all Cyprus banks, independent of how much trouble a given bank was in. The banks closed down before this was announced so people couldn’t grab their money.

Compare that to the US version of a bailout from 2008, when shareholders got partially screwed, bondholders were left whole, deposits were untouched, but taxpayers were on the hook (and still are).

Plan #1 was baldfaced: it was saying to the average person in Cyprus, “Hey we fucked up the banks, can we take your money to fix it?”. It was incredible that anyone thought it would work. The ramifications of such an anti-FDIC insurance would be immediate and contagious, namely everyone in any related country would immediately start pulling their money out of banks. Why keep your money in an institution where you’re surely losing 7% when you can hide your money in a suitcase with only a small chance of it getting stolen?

Reaction by public: Hell No

Needless to say, the people in Cyprus didn’t like the plan. In fact, they strongly objected to directly paying for the mistakes of rich bankers and to protect Russians. They protested loudly and the Cypriotic politicians heard them, and voted down plan #1.

Plan #2

Since plan #1 failed, how about we just take money from uninsured depositors? Oh, and also make it bank-specific. So the banks that are in bigger poo-poo would seize more of their deposits than the banks that were in less poo-poo. That makes sense, and seems to be the current plan.

Problems with the current plan

There are a few problems with the new plan. But mostly they are what I’d call transition costs versus long-term problems. Easy for me to say, since I don’t live in Cyprus.

Rich people moving their money

First, rich people everywhere will no longer park lots of money in uninsured accounts in weak banks. Rich people have lots of options, though, so don’t feel too bad for them. They will instead put their money into lots of little accounts in lots of places, each of which will be insured. If this means they distribute their money over more banks, this is good for the banking system because it diversifies the capital and we’d end up with lots of biggish banks instead of a few enormous banks.

I’m not sure what the technical rules are, though. Say I’m stinking rich. Can I open 15 Bank of America accounts, each with $250K and so FDIC-insured? If I can’t do that for my local Bank of America branch, can I use Bank of America subsidiaries? Are the rules the same in the US and Europe? These rules are all of a sudden more important.

This is a transition cost, and within a few months all of the rich people will have their accounts insured or hidden.

Job losses

Second, there will be severe job losses in the bloated finance sector in Cyprus. Right now there are protests by workers from Laiki Bank, which is the worst off Cyprus bank, because they’re poised to lose their jobs. Again, it’s easy for me to say since I don’t live in Cyprus, but that’s what happens when you have an industry that’s too big – at some point it gets smaller and people lose jobs. I was around when the same thing happened to fisherman off the coast of New England, and it wasn’t pretty.

Again, though, it’s transitional. At some point the number of people working in banks in Cyprus will be reasonable. The question is whether they will have found another industry to replace finance.

Capital controls

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The banks re-opened today, and of course people are standing in line to get cash, but things generally seem calm.

The big problem for businesses in Cyprus is that various “temporary” capital controls (which just means limits on taking money out of the country and on taking money from your bank) have been put into place that may lead to long-term problems.

Update (hat tip commenter badmax): many Russians already took their money out before the capital controls were imposed.

Euros don’t flow into and out of Cyprus effortlessly anymore, so the so-called monetary union has been broken. Depending on how quickly those rules are removed, and how quickly Cyprus comes up with other things to do, this could be a huge problem for the country.

Take-aways

  • What’s become blatantly clear by following this process is that there is no actual process. Things are being made up as they go along by a bunch of economists and finance ministers. A lot of faith in their abilities was lost permanently when they hatched plan #1 which was so obviously stupid.
  • Going back to that stupid plan, whereby normal depositors were supposed to pay for the mistakes of banks at the expense of their insured deposits. It was so bald-faced that the citizens rebelled, and politicians listened. So just to be clear, there has been actual input by average people in this process. The economists and finance ministers have lost face and the people have found a voice.
  • This is not to say that the Cyprus people are sitting pretty. They are not, and by some estimates the economy of Cyprus is poised to contract by 20%. This may lead to more bailouts or Cyprus leaving the Eurozone for good.