The Cyprus economy is $23 billion. (The Vermont economy is $26 billion.) Bank loans in Cyprus are eight times the size of GDP, compared with 3.5 times in the Eurozone and 1 times U.S. GDP. With leverage ratio’s that high, a small deterioration in loan performance can render the banking system insolvent.
Cyprus is located 578 miles from Greece, and 28 percent of bank loans are to the Greeks. The Greek economy has declined nearly 25 percent since 2008. By way of the transitive property, the Cypriotic banking system has therefore failed. To avoid default, the banks need capital equivalent to about 60 percent of Cyprus’ GDP. If the Cyprus government attempted to recapitalize the banks, total government debt to GDP would rise from 85 percent to 145 percent. No one will lend them the money for that. They have no mechanism to fix their problem domestically. Bailout time!
The Eurozone leaders know that the Cyprus banking system contains somewhere near $25 billion in Russian deposits, thanks to favorable tax rates and lax money laundering laws. The European powers recognize that this incentive system attracts far too much capital leading to high leverage ratios and poor underwriting decisions. With Cyprus in need of $20.5 billion, the Euro powers offered $13 billion and told them to come up with the remaining $7.5 billion … perhaps suggesting that they confiscate bank deposits as a way to chastise the Russians.
Local depositors protested, and Parliament unanimously voted the proposal down. Plan A: Rejected. Next? Time to negotiate with the Russians directly. After all, Cyprus does have natural gas and other strategic assets to barter with. Unfortunately, the Russians didn’t appear interested in doubling down on Cyprus. Plan B: Rejected. Now what? Nationalize pension funds, sell off future natural gas revenue, mortgage church properties, set up capital controls, confiscate Russian deposits, ask for donations .,. it’s all on the table, and Cyprus has until Tuesday to figure it out, or the system fails and they exit the Euro.
Should you care?
Financial markets have largely shrugged off this debtor drama. Cyprus is small and insignificant to the world economy, and if Europe needs to beta-test Euro expulsion, Cyprus makes the ideal candidate. Worries about a broad loss of investor confidence appear overblown as Spain issued sovereign debt last week at yields below the current market, and fears of reactionary bank runs across Europe have not materialized.
Gold opened last week at 1604 and closed the week at 1608. The S&P 500 opened the week at 1560.70 and closed the week at 1556.35 for a change of -.25 percent. So far, it’s a non-event. Investor skin has clearly thickened. Political wiggles in Washington and Europe elicit smaller sell-offs and fewer instantaneous dire forecasts. Market participants have become less sentimental and more fundamental, placing higher value on economic and earnings information. This is a very healthy turn for these histrionic markets.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.