Monday, 18 March 2013

Europe Welcomes the new CoCo Deposits

In an unprecedented and highly risky decision, Europe ordered the Cypriot government to convert a portion of retail deposits to common equity in order to save the Cypriot banks from collapse and the country from exiting the Euro. The total bailout cost was estimated at around 17billion. However, the IMF and apparently the German government did not want to bail out the Cypriot banks unless there was some form of bail-in. So they created something totally new in the world of finance. They made deposits the next Contingent Convertible capital. In other words they relegated the deposits from the Senior position to Hybrid capital. This is a humongous change. Deposits in the past have been lost due to default and bankruptcy but never converted forcefully to equity. The EU has really crossed the line here.This alters the perception of deposits and renders any Deposit Guarantee Schemes useless. No senior or subordinated holders suffered any losses which is rather amazing given that depositors where short changed.

Political decision. Greece, Cyprus next Italy and Spain?
Let us be absolutely clear. This was not a mistake due to ignorance or miscalculation. This was a deliberate policy decision and not one based in economics. After all the size is rather small, only 17billion. In other words, they chose the option to cut the deposits not because they had no other option but because they wanted to pass a political message. The small size of Cyprus is ideal for laboratory purposes and for teaching others a lesson.  The question is, why throw kerosene to the Euro fire when things were seemingly getting better? Why now? Italy does not have a government and this would increase the tension. When the next country starts negotiation for a bailout (Italy, Spain etc) what other trick would the Eurogroup invent? In Ireland they used the pension fund money, in Greece they made a forced restructuring with more than 75% losses, in Cyprus they are touching the retail deposits. What would be the next solution for Spain and Italy? Could we have yet again another “one-off” solution? Assets in these countries have become slightly riskier this morning. Who benefits from a possible crisis escalation? Was it just the case of domestic political pressure in Germany and Finland?
Market Implications
It is not clear how the market would react to the news. It is not the financial size of the problem but the apparent paradigm shift in perceptions. Europe behaves like the worst third world debt offender. This is the first Corralito in the Eurozone! Market’s behavior in the short term depends on Cyprus reaction.
·         If the Cypriot parliament approves the decision (2pm London time) then we only have the long term repricing effects of a really bad European decision.
·         If on the other hand the parliament fails, then we are escalating the Euro-crisis. Could Cyprus threaten to leave the Eurozone? Could Eurogroup take back or at least amend the decision?
o   It seems that as of Sunday the government did not have the support of the parliament, which is why they postponed the vote for Monday. It also helps to see if the markets would help Cyprus’s case by causing chaos.
o   Can Cyprus deal with the default without Eurozone’s help? Can they somehow cause a default in their sovereign bonds and the bank without a social upheaval and a forced Eurozone exit?
o   Financially Cyprus could exit the Eurozone. The cost to the economy is not easily calculated. Yes, initially there would be chaos but the fundamentals of the economy and the future receipts from the proven oil and gas reserves would probably remedy any ills.Could the re-introduction of the Cypriot pound be a solution?
o   The main problem with the exit scenario in my view is geostrategic. Cyprus needs Europe for political reasons. It is a divided island and needs the protection and partnership with the EU. Thus, unless it can quickly re-align its alliances the exit scenario is suicidal.
·         What would be the reaction to other European countries that are in the process of recapitalizing their banks? For example, in Greece this is an ongoing process. Could Eurogroup threaten Greece with the same fate unless they adhere to the MOU? What would this mean for the Greek deposits?
·         How about Spain and Italy? What would happen to deposits if one day they announce that they are starting negotiations with a view to activate the OMT program? Could recapitalizing the banks through a portion of retail deposits be a condition? The Pandora’s Box half opened when the Greek PSI forced losses on bond holders. Now it is fully opened with retail depositors suffering losses.
·         The IMF conducted a Debt Sustainability Analysis(DSA) that for sure did not take into account the total destruction of the deposit base or the consequences that such a decision may have upon the economy of Cyprus. Most DSA are fiction anyway, but this one may be rendered useless much sooner. In other words more measures maybe on the way for the Cypriots.
·         A conspiracy theorist (which I am not) could argue that this may work in favor of Germany and other AAA countries. This is how: as deposits flee the southern countries they find their way in the northern countries. What this means is that in a possible euro breakup the Target2 imbalances could be netted off with the non-resident deposits in Germany (for example) thus minimizing the cost to Germany. So by negating the deposit insurance guarantee they make sure that Germany is going to lose less!
Cyprus Deposits losers in Numbers. British Deposits.
Cypriot banks held at the end of January 2013 around €68bln. Out of these 68bln, 42bln belong to domestic depositors, 4.7bln to other European citizens (mainly Greeks) and the rest 20bln (4.5bln to other FI, 11.3 to corporates and 4.8 households) to non-EZ citizens. This includes a GBP 1.2billion presumably owned by mostly British citizens that could suffer a maximum of 120miilion losses. So a minimum of 4.8billon can be collected if we apply the 6.75% rate. Troika things it can collect 5.8billion.
Most depositors in Cyprus were caught by surprise. Some of the Greek money that fled to Cyprus went back to Greece. It is estimated that out of the 5billion that left Greece for Cyprus only 1.8billion had return to Athens. Thus, Greek depositors would suffer 200-300million losses.
Data from the bank of Cyprus also show that at in January 2013 627million of deposits held by non-EU citizens have fled. In other words there was no serious run on the Cypriot deposits. This may change the next few days.
An appalling decision. Deposits for Equity swap.
The best financial minds, academics and technocrats wrestled with the question of how to recapitalize the banks in Greece, Spain, Ireland, and other Eurozone countries and who is going to pay for it. Euro area finance ministers and the IMF on the other hand had the answer in front of them. They will implement a “debt for equity swap” without the consent of the debt holders and instead of using normal Senior or Subordinated debt they would use retail deposits. It is that simple. Why I did not think of that!!
Lawyers and PhD students rejoice. The EU has just created ample material for generations to study, litigate and write about.
The branches of Cypriot banks in Greece (with 18bln in deposits) are saved and would probably be given to a Greek bank as a parting gift (Postal bank seems to be the winner).
Cyprus financial position. Socializing the banks.
It is clear that Cyprus is facing a rather big problem. The island’s banks had grown in size many times its GDP (8 times). A milestone in this rather abnormal growth was the decision of the Greek bank Marfin to acquire Laiki Bank of Cyprus and move its operations and balance sheet to Cyprus from Greece. Marfin was a much bigger bank than Laiki and had the majority of its risk exposure in Greek assets or Bonds. Other, more genuinely Cypriot banks also had a significant exposure to Greek assets. With Greece defaulting and the ongoing recession the losses on Cypriot banks multiplied. It is also true that Cyprus experienced a real estate boom in the recent years and that the previous administration inflated Cyprus debt. So, Cyprus found itself in a similar position to that of Ireland a few years ago. In other words, they were faced with the dilemma of either supporting and recapitalizing the banks or oblivion. In both cases, anecdotal evidence suggests that the ECB issued an ultimatum to the government. In the Irish case the state i.e. the taxpayers took on the burden by directly guaranteeing the banks.  In doing so they saved the senior bond holders, mainly British and other European institutional bondholders to the detriment of Irish pensioners and taxpayers.
In Cyprus on the other hand they are doing the unthinkable. They are delving directly in the retail deposits. As of this morning all deposits of less or equal than 100,000 are worth less or equal 93,250 plus a piece of papers (share certificate) that no one as yet knows how much is worth or what is written on it (it would be determined later on by ministerial decision). For those “lucky” enough to have more than 100,000 the haircut is 9.99% instead of 6.75% plus the same piece of share certificate. There are reports of course that the Cypriot government is renegotiating the bands trying to get the 6.75% reduced to 3% and introducing a new 12,5% for deposits of over 500k in order to convince MP to support the deal today.
Of course one would argue that this is the perfect example of socializing the banks. The parties on the left (like Die Linke in Germany and SYRIZA in Greece) should rejoice. Give the banks back to the people. The problem is that no-one asked the people whether they want to be forced shareholders of bankrupt banks or not.
Deposit as Contingent Convertible Capital
For many-many years the capital structure of a bank was stable. In case of default, the losses would eat away first the equity capital, then Tier1 Hybrid capital, then the subordinated debt and the senior debt and lastly the depositors. In recent years another financial instrument was created, the Contingent Convertible capital or CoCo.
Very simply, this is a debt instrument that converts into common equity if and when the bank is at risk from losses or some financial ratio falls below a threshold. Many banks including Barclays, Lloyds and others have issued such instruments. In this way, senior debt holders and depositors are given an added protection should things go wrong. 
The decision by Eurogroup to bail-in the depositors by forcing them to convert part of their money to equity is unprecedented not only because it steels people’s deposits but because it formally changes the hitherto position of depositors as senior creditors. It treats retail deposits as Hybrid capital or CoCo. There is no default and no official credit event as far as I understand. The EU has done something similar when it exempted the ECΒ from the Greek PSI thus creating a new class called “preferred investor” (and not creditor since the ECB cannot be a creditor to a country).
Thus with one stroke the EU has rearranged the capital order of a Bank. Instead of Common Equity, Subordinated debt Senior Debt and deposits it reversed the order. This is by far the most ominous sign for things to come.
Why was it baptized “levy” and why the Deposit Guarantee Scheme failed?
EU directive 94/19/EC deals with the Deposit Guarantee Schemes (DGS). Since 31 Dec 2010 the deposit insurance was raised to €100,000. So why did the Eurogroup decision demands a 6.75% levy for deposits of less than 100k. And why is it baptized as a “levy” when the depositor gets swapped into equity? Perhaps the word levy is used to avoid the legal complication of expropriation, especially by foreign depositors that might breach Bilateral Investment Treaties that Cyprus has signed. As of 2011 there were 23 BIT but only 16 seemingly were ratified and Russia was not one of them (data as of 2011). These now can sue the Cypriot government for inadequate compensation.
With regards to why the DGS was not activated the logic gets more convoluted. One can argue that since, technically speaking the banks did not declare bankruptcy the DGS is not activated. Needless to say that the DGS did not activate (as yet) precisely because the deposits were forcefully converted to equity!!! For this argument to work, senior bond holders must be left untouched which is absurd. So, not only you convert deposits to equity but you also leave other less senior debt holders untouched.
Here however, one can mention Article 1.3 of EU directive 94/19/EC which defines:

‘unavailable deposit’ shall mean a deposit that is due and payable but has not been paid by a credit institution under the legal and contractual conditions applicable thereto, where either: (i) the relevant competent authorities have determined that in their view the credit institution concerned appears to be unable for the time being, for reasons which are directly related to its financial circumstances, to repay the deposit and to have no current prospect of being able to do so.

In other words, if the (in)competent authorities determine that the banks appears to be unable to repay the deposit then the DGS should be activated. This looks like to be the case here, but the needs of the highest Public Interest need also to be counted in.
Whatever the case, the DGS is for all practical purposes dead. Anyone, who things that his money is insured up to 100k is dreaming without the EU. The EU managed to insert doubts in the bond market and now is doing the same in the deposits.

Highest Public Interest

Such extraordinary measures can only be taken by a country under extreme circumstances. When Greece unilaterally changed the terms of all bond contracts under Greek law, they did it on the basis of article 9 of EU 593/2008. This allows a country to suspend contractual law if it is in the highest public interest.  
In the Cyprus case the draft law mentions (own translation)
1.      Since there is a need to safeguard the financial stability and to avoid any destabilizing factors that may seriously shake the whole of the Cypriot economy with unforeseen socioeconomic consequences
2.      And since there is a need to secure the viability and the smooth functioning of the financial institutions of the Republic and recognizing the inability of finding funds for the recapitalization of these credit institutions that may cause catastrophic consequences in the economy, the society and with serious consequences in the total wealth
3.      And since the implementation of a levy on deposits is a necessary and timely source of funds
We decide…….
Although they do not explicitly mention the words Public Interest they are trying to describe it. In any case, converting deposits to equity shares in failed banks is for sure in the interests of someone but possibly not the depositor.


For the second time Europe has shown that it is not mature enough to even keep the basic fundamentals tenets of an advanced modern state. Banks are not allowed to collapse and senior debt holders as yet are shielded from taking losses. On the other hand violating the sanctity of retail deposits is ok. I wonder what the Eurogroup would force upon the Italians and the Spanish. EU keeps surprising us in a negative way.