If you missed it, Cyprus announced it will levy a one time tax on deposits to lower the liabilities of the banking system by about 5.8 billion euros. The problem in Cyprus is that the banking system is missing about 8 billion euros which is about 50% of GDP. The number itself is not big, however if Cyprus was to borrow that money to pay deposits, it would mean that its debt would increase to about 150% of GDP and thus make the economy insolvent.
So even assuming that the troika would put up the money (AKA the German taxpayer), the most likely scenario is that Cyprus would need a haircut on its foreign debt sooner or later. So the problem in Cyprus is that whoever puts up the money today, will most probably lose money down the road.
The problem in Cyprus, as in all of Europe, is that unfortunately there is no pan-European FDIC type of organization and many times local regulators let things get out of control.
The issue in Cyprus is not the haircut on deposits, but the fact they are trying to levy a tax on the entire banking system, as apposed to just the banks that have the problem. In other words, it's an issue of civil liberties and property rights.
And I am actually shocked to hear Germany's Wolfgang Schäuble say that the ECB and the European Commission actually gave the go ahead with this scheme.
So how do you play this? Several months ago I told you to sell European banks and buy U.S. banks (please consider: Operation Bank Twist: Sell European Banks, Buy U.S. Banks). I still stand by that call. And if we look at how several big U.S. and European banks have performed over the past 12 months, U.S. banks like Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC) have outperformed European heavyweight counterparts like Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS).
Generally speaking what can happen in Cyprus can happen anywhere in Europe and to be honest, I expect a lot more of it in the future. Italy, Spain and Ireland are the front runners.
So besides specific U.S. banks outperforming European counterparts, I would also say that the whole European banking sector should be downgraded in investor portfolios.
As for the euro (NYSEARCA:FXE), the Cyprus issue is a non-event, however what is important to note is that investors will sell euros and move to the U.S. dollar, out of fear that it might happen to them - even in a German bank. Because there is no safety when a bank like Deutsche Bank is still is leveraged about 50 times.
Sell European banks and the euro at the same time. Not because of what has happened in Cyprus, but because European banks are still in a mess and it will take several trillion euros in central bank printing to clear up the mess in Europe (please consider:Why Printing Euros Will Make The EURUSD Rise).
And until they print that money and recapitalize the banks with the mechanism I have told you (also consider: How To Solve The Greek Debt Crisis Without Taxpayer Funds), there is no safety in Europe.
The Cyprus incident is not going to spread or cause panic in any way, it's just a good reminder of why you should not be invested in the European financial sector long term for the time being.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.